Misdiagnosis of 2008 and the Fed: Inflation Targeting Was Not the Problem. An Unwillingness to Vaporize Asset Values Was Not the Problem…

Posted on by Brad DeLong

This, from the very sharp Martin Wolf, seems to me to go substantially awry when Martin writes the word “convincingly”. Targeting inflation is not easy: you don’t see what the effects of today’s policies are on inflation until two years or more have passed. Targeting asset prices, by contrast, is very easy indeed: you buy and sell assets until their prices are what you want them to be.

As I have said before, as of that date January 28, 2004, at which Mallaby claims that Greenspan knew that he ought to “vaporise citizens’ savings by forcing down [housing] asset prices” but had “a reluctance to act forcefully”, that was not Greenspan’s thinking at all. Greenspan’s thinking, in increasing order of importance, was:

  1. Least important: that he would take political heat if the Fed tried to get in the way of or even warned about willing borrowers and willing lenders contracting to buy houses and to take out and issue mortgages.

  2. Less important: a Randite belief that it was not the Federal Reserve’s business to protect rich investors from the consequences of their own imprudent folly.

  3. Somewhat important: a lack of confidence that housing prices were, in fact, about fundamentals except in small and isolated markets.

  4. Of overwhelming importance: a belief that the Federal Reserve had the power and the tools to build firewalls to keep whatever disorder finance threw up from having serious consequences for the real economy of demand, production, and employment.

(1) would not have kept Greenspan from acting had the other more important considerations weighed in the other direction: Greenspan was no coward. William McChesney Martin had laid down the marker that: “If the System should lose its independence in the process of fighting for sound money, that would indeed be a great feather in its cap and ultimately its success would be great…” Preserving your independence by preemptively sacrificing it when it needed to be exercised was not Greenspan’s business. (2) was, I think, an error–but not a major one. And on (3), Greenspan was not wrong:

S P Case Shiller 20 City Composite Home Price Index© FRED St Louis Fed

Nationwide, housing prices today are 25% higher than they were at the start of 2004. There is no fundamental yardstick according to which housing values then needed to be “vaporized”. The housing bubble was an issue for 2005-6, not as of the start of 2004.

It was (4) that was the misjudgment. And the misjudgment was not that the economy could not handle the adjustment that would follow from the return of housing values from a stratospheric bubble to fundamentals. The economy handled that return fine: from late 2005 into 2008 housing construction slackened, but exports and business investment picked up the slack, and full employment was maintained:

Macroeconomic Overview Talk for UMKC MBA Students April 1 2013 DeLong Long Form

The problem was not that the economy could not climb down from a situation of irrationally exuberant and elevated asset prices without a major recession. The problem lay in the fact that the major money center banks were using derivatives not to lay subprime mortgage risk off onto the broad risk bearing capacity of the market, but rather to concentrate it in their own highly leveraged balance sheets. The fatal misjudgment on Greenspan’s part was his belief that because the high executives at money center banks had every financial incentive to understand their derivatives books that they in fact understood their derivatives books.

As Axel Weber remarked, afterwards:

I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions…. The industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them…

That elite money center financial vulnerability and the 2008 collapse of that Wall Street house of cards, not the unwinding of the housing bubble, was what produced the late 2008-2009 catastrophe:

Macroeconomic Overview Talk for UMKC MBA Students April 1 2013 DeLong Long Form

Greenspan’s error was not in targeting inflation (except at what in retrospect appears to be too low a level). Greenspan’s error was not in failing to anticipatorily vaporize asset values (though more talk warning potentially overleveraged homeowners of risks would have been a great mitzvah for them). Greenspan’s error was in failing to regulate and supervise.

Martin Wolf: Man in the Dock:

Of his time as Fed chairman, Mr Mallaby argues convincingly that:

The tragedy of Greenspan’s tenure is that he did not pursue his fear of finance far enough: he decided that targeting inflation was seductively easy, whereas targeting asset prices was hard; he did not like to confront the climate of opinion, which was willing to grant that central banks had a duty to fight inflation, but not that they should vaporise citizens’ savings by forcing down asset prices. It was a tragedy that grew out of the mix of qualities that had defined Greenspan throughout his public life—intellectual honesty on the one hand, a reluctance to act forcefully on the other.

Many will contrast Mr Greenspan’s malleability with the obduracy of his predecessor, Paul Volcker, who crushed inflation in the 1980s. Mr Greenspan lacked Mr Volcker’s moral courage. Yet one of the reasons why Mr Greenspan became Fed chairman was that the Reagan administration wanted to get rid of Mr Volcker, who “continued to believe that the alleged advantages of financial modernisation paled next to the risks of financial hubris.”

Mr Volcker was right. But Mr Greenspan survived so long because he knew which battles he could not win. Without this flexibility, he would not have kept his position. The independence of central bankers is always qualified. Nevertheless, Mr Greenspan had the intellectual and moral authority to do more. He admitted to Congress in 2008 that: “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.” This “flaw” in his reasoning had long been evident. He knew the government and the Fed had put a safety net under the financial system. He could not assume financiers would be prudent.

Yet Mr Greenspan also held a fear and a hope. His fear was that participants in the financial game would always be too far ahead of the government’s referees and that the regulators would always fail. His hope was that “when risk management did fail, the Fed would clean up afterwards.” Unfortunately, after the big crisis, in 2007-08, this no longer proved true.

If Mr Mallaby faults Mr Greenspan for inertia on regulation, he is no less critical of the inflation-targeting that Mr Greenspan ultimately adopted, albeit without proclaiming this objective at all clearly. The advantage of inflation-targeting was that it provided an anchor for monetary policy, which had been lost with the collapse of the dollar’s link to gold in 1971 followed by that of monetary targeting. Yet experience has since shown that monetary policy is as likely to lead to instability with such an anchor as without one. Stable inflation does not guarantee economic stability and, quite possibly, the opposite.

Perhaps the biggest lesson of Mr Greenspan’s slide from being the “maestro” of the 1990s to the scapegoat of today is that the forces generating monetary and financial instability are immensely powerful. That is partly because we do not really know how to control them. It is also because we do not really want to control them. Readers of this book will surely conclude that it is only a matter of time before similar mistakes occur.

The root problem of 2008 was not that inflation targeting generates instability (even though a higher inflation target then and now would have been very helpful). The root problem of 2008 was not that the Federal Reserve was unwilling to vaporize asset values–the Federal Reserve vaporized asset values in 1982, and stood willing to do so again *if it were to seem appropriate*. The root problem of 2008 was a failure to recognize that the highly leveraged money center banks had used derivatives not to distribute subprime mortgage risk to the broad risk bearing capacity of the market as a whole but, rather, to concentrate it in themselves.

At least as I read Mallaby, he does not criticize Greenspan for “inertia on regulation” nearly as much as he does for Greenspan’s failure to “vaporise citizens’ savings by forcing down asset prices…” even when there is no evidence of rising inflation expectations or excess demand in the goods and labor markets as a whole.

Axel Weber’s full comment:

I think one of the things that really struck me was that, in Davos, I was invited to a group of banks–now Deutsche Bundesbank is frequently mixed up in invitations with Deutsche Bank.

I was the only central banker sitting on the panel. It was all banks. It was about securitizations. I asked my people to prepare. I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions.

When I was at this meeting–and I really should have been at these meetings earlier–I was talking to the banks, and I said: “It looks to me that since the buyers and the sellers are the same institutions, as a system they have not diversified”. That was one of the things that struck me: that the industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them.

What was missing–and I think that is important for the view of what could be learned in economics–is that finance and banking was too-much viewed as a microeconomic issue that could be analyzed by writing a lot of books about the details of microeconomic banking. And there was too little systemic views of banking and what the system as a whole would develop like.

The whole view of a systemic crisis was just basically locked out of the discussions and textbooks. I think that that is the one big lesson we have learned: that I now when I am on the board of a bank, I bring to that bank a view, don’t let us try to optimize the quarterly results and talk too much about our own idiosyncratic risk, let’s look at the system and try to get a better understanding of where the system is going, where the macroeconomy is going. In a way I take a central banker’s more systemic view to the institution-specific deliberations. I try to bring back the systemic view. And by and large I think that helps me understand where we should go in terms of how we manage risks and how we look at risks of the bank compared to risks of the system.

Must-Read: Martin Wolf: The Man in the Dock

Posted on by Brad DeLong

Must-Read: This, from the very sharp Martin Wolf, seems to me to go substantially awry when Martin writes the word “convincingly”.

With that word, Wolf appears to buy into Mallaby’s misdiagnosis of the problem of 2008.

The root problem of 2008 was not that inflation targeting generates instability (even though a higher inflation target then and now would have been very helpful). The root problem of 2008 was not that the Federal Reserve was unwilling to vaporize asset values–the Federal Reserve vaporized asset values in 1982, and stood willing to do so again if it were to seem appropriate. The root problem of 2008 was a failure to recognize that the highly leveraged money center banks had used derivatives not to distribute subprime mortgage risk to the broad risk bearing capacity of the market as a whole but, rather, to concentrate it in themselves:

Martin Wolf: Man in the Dock:

Of his time as Fed chairman, Mr Mallaby argues convincingly that:

The tragedy of Greenspan’s tenure is that he did not pursue his fear of finance far enough: he decided that targeting inflation was seductively easy, whereas targeting asset prices was hard; he did not like to confront the climate of opinion, which was willing to grant that central banks had a duty to fight inflation, but not that they should vaporise citizens’ savings by forcing down asset prices. It was a tragedy that grew out of the mix of qualities that had defined Greenspan throughout his public life—intellectual honesty on the one hand, a reluctance to act forcefully on the other….

Mr Greenspan lacked Mr Volcker’s moral courage. Yet… Mr Greenspan survived so long because he knew which battles he could not win…. Nevertheless, Mr Greenspan had the intellectual and moral authority to do more…. Greenspan also held a fear and a hope. His fear was that participants in the financial game would always be too far ahead of the government’s referees and that the regulators would always fail. His hope was that “when risk management did fail, the Fed would clean up afterwards.” Unfortunately, after the big crisis, in 2007-08, this no longer proved true. If Mr Mallaby faults Mr Greenspan for inertia on regulation, he is no less critical of… inflation-targeting…. Monetary policy is as likely to lead to instability with such an anchor as without one…

But at least as I read Mallaby, he does not criticize Greenspan for “inertia on regulation” nearly as much as he does for Greenspan’s failure to “vaporise citizens’ savings by forcing down asset prices…” even when there is no evidence of rising inflation expectations or excess demand in the goods and labor markets as a whole.

Must-Read: Noah Kaplan et al.: nderstanding Persuasion and Activation in Presidential Campaigns: The Random Walk and Mean Reversion Models

Posted on by Brad DeLong

Must-Read: Noah Kaplan et al.: Understanding Persuasion and Activation in Presidential Campaigns: The Random Walk and Mean Reversion Models:

Political campaigns are commonly understood as random walks…

…during which, at any point in time, the level of support for any party or candidate is equally likely to go up or down. Each shift in the polls is then interpreted as the result of some combination of news and campaign strategies. A completely different story of campaigns is the mean reversion model in which the elections are determined by fundamental factors of the economy and partisanship; the role of the campaign is to give voters a chance to reach their predetermined positions. Using a new approach to analyze individual level poll data from recent presidential elections, we find that the fundamentals predict vote intention increasingly well as campaigns progress, which is consistent with the mean-reversion model, at least at the time scale of months. We discuss the relevance of this finding to the literature on persuasion and activation effects.

Must-Read: Greg Ip: Fiscal Policy Makes a Quiet Turn Toward Stimulus

Posted on by Brad DeLong

Must-Read: Five years late, and many trillions of dollars short. But still…

Greg Ip: Fiscal Policy Makes a Quiet Turn Toward Stimulus:

Now… fiscal policy across the developed world is collectively turning more stimulative for the first time since the end of the recession…

…This may be the most underappreciated economic development of the year. While the scale of the stimulus is modest in dollar terms, it signals a more profound shift in the political winds. Globally, the rise of political populism has pushed deficits down the list of priorities while elevating tax cuts and benefits for the working class. With enough critical mass, such measures could persuade central banks to rethink their own super-easy monetary policies, which would undermine the case for today’s rock-bottom bond yields and pricey stocks.

The fiscal shift is easy to miss, because rhetorically at least, governments remain devoted to cutting their debts. But numbers tell a different story…. The near-term catalyst for the fiscal turn was Britain’s vote to leave the European Union on June 23. Not only did the resulting uncertainty threaten global economic growth, it also alerted centrist political parties to how unhappy voters are with the economic status quo….

For Japan, the impetus was both Brexit and the Bank of Japan’s introduction of negative interest rates this year, which failed to work as planned; the yen went up and stocks went down. In August, Prime Minister Shinzo Abe unveiled a $73 billion package of infrastructure spending, cash handouts to poor families, and other stimulative measures. In the U.S., budget caps enacted in 2011 have already been loosened. Meanwhile, Hillary Clinton, the Democratic nominee, is campaigning to boost spending on countless programs, from college education to infrastructure…. Mr. Trump’s rise demonstrates that austerity has lost the political energy it had in 2010….

Central bankers can take credit for the shift. As the benefits of zero to negative rates have shrunk and the side effects risen, they have exhorted finance ministers to take up the burden of supporting growth…

Alan Greenspan Misjudged the Risks in the Mid-2000s; Alan Greenspan Was Not a Coward

Posted on by Brad DeLong

The standard explanations I have heard for Alan Greenspan’s policy of “benign neglect” toward the mid-2000s housing bubble–why he turned down the advice of Ned Gramlich and others to use his regulatory and jawboning powers against it–see Greenspan as motivated by three considerations:

  1. Least important: that he would take political heat if the Fed tried to get in the way of or even warned about willing borrowers and willing lenders contracting to buy houses and to take out and issue mortgages.

  2. Less important: a Randite belief that it was not the Federal Reserve’s business to protect rich investors from the consequences of their own imprudent folly.

  3. Of overwhelming importance: a belief that the Federal Reserve had the power and the tools to build firewalls to keep whatever disorder finance threw up from having serious consequences for the real economy of demand, production, and employment.

Back in the mid-2000s Greenspan had a strong case.

I certainly, bought it by and large. The Federal Reserve had, after all, managed to deal with the 1987 stock market crash, the 1991 S&L crash, the 1995 Mexican crash, the 1997 East Asian crisis, the 1998 dual bankruptcy of Russia and LTCM, the 2000 collapse of the dot-com bubble, and 9/11–plus assorted smaller financial disturbances. And it had dealt with them well.

Thus the interpretation of Alan Greenspan’s actions in the mid-2000s that I have always believed in is: he misjudged the risks, and unknowingly made bad calls.

Now comes Sebastian Mallaby with a different interpretation. Mallaby’s interpretation of Greenspan in the mid-2000s is: he understood the risks, but was too cowardly to do his proper job:

Sebastian Mallaby: The Doubts of Alan Greenspan:

Mr. Greenspan was not complacent about potential catastrophes lurking in balance sheets—he had worried about them for decades. Far from being ignorant of these issues, he was the man who knew….

In Jan. 2004, with house prices starting to look frothy, Mr. Greenspan repeated his warning, predicting a repeat of the tech bust. “It sounds as though we’re back in the late ’90s,” he worried to his colleagues. “The potential snap-back effects are large.” In short, Mr. Greenspan’s youthful fear of finance stayed with him throughout his Fed tenure. Long before the 2008 crisis, he had understood the lessons that were celebrated as new insights in the wake of the crash…

This seems to me to be simply wrong as an interpretation of the mid-2000s.

Here’s the context of the Greenspan quotes, from the January 28, 2004 FOMC meeting. Greenspan is building the case for removing from the FOMC post-meeting statement the phrase that it will wait a “considerable period” before it will start to raise the Fed Funds rate from its then-current level of 1%/year, and to replace that with a reference to “patience” before it will start to raise the Federal Funds rate.

Greenspan:

President Broaddus, did you have a question? Are there any other questions? If not, let me get started. I must say after listening to this roundtable discussion that I find it hard to recall a degree of buoyancy like the one that comes across today. Unless I’m mistaken, Committee members have not reported on indications of a more unequivocally benign and positive economic outlook in a number of years. It sounds as though we’re back in the late ’90s or perhaps early 2000. That, I suspect, is a reflection of what is going on in the economy. Indeed, on the basis of both the Beige Book and today’s roundtable discussion of regional developments, the data that will be forthcoming from official agencies, if my experience serves me well, are going to come in surprisingly on the upside. The outlook seems extraordinarily benign, and I’ll get to the reasons why that bothers me shortly.

Profits margins are high though they may have peaked and probably will be edging downward. At this stage the usual lag between productivity growth and its effects on real compensation is likely to result in increasing incomes and thus provide a fairly solid base for further growth in consumer spending as the impact of earlier tax cuts fades. The wealth effect, which has been a drag on spending for quite a long period of time, is now back to neutral or possibly has turned positive; and in my view, the consumer debt service burdens that one hears about from most of our private-sector colleagues are really being overstated. If we look, for example, at the debt service burden on home mortgages, we find that a very large number of homeowners have refinanced and have locked in a very low coupon rate on average. That suggests that most mortgage credit servicing payments are going to be relatively flat irrespective of what we do in the marketplace. And while we likely are looking at an increase in the consumer credit part of household indebtedness, it is mortgages, of course, that dominate the overall household sector debt.

On the business side it has already been mentioned that the financing gap has turned negative for the first time in quite a significant period, and we’re seeing the implications of an increase in cash flow on capital investment. We’re seeing it in the anecdotal information on capital appropriations and certainly in the new orders series, which are continually improving. Inventory investment has nowhere to go but up. The Institute of Supply Management reports that purchasing managers continue to view the inventories of their customers as exceptionally low. The implication is that new orders will strengthen, and we’re even hearing some discussions about a prospective pickup in commercial lending; that has not yet happened, but it would be another indication of a surge in inventory investment. The housing market is bound to soften at some point, but we’ve been saying that for quite a long period of time. In any event, it’s hard to imagine that housing activity will contribute very much in the way of strength to the expansion. Net exports will probably continue to be a small drag. Inflation clearly is stable.

I think the employment data are actually a good deal better than the latest payroll numbers suggest. If we look at the change in employment as the difference between gross hires less gross separations, the gross separation series as best we can judge is pretty much what we would expect given the GDP growth numbers that we have been looking at. Initial claims are down significantly as are job losses. What’s happening is that new hires are well below expectations in relation to economic growth, and I suspect that virtually all of that weakness is merely a mirror image of the increase in output per hour. Indeed, the question here is how much longer we can continue to get such rapid increases in output per hour. I do not deny that we may get additional quarters with 5 percent productivity growth rates, but if that goes on much longer, it will become historically unprecedented.

An economy characterized by cutting-edge technology such as in the United States does not seem capable of expanding much faster than 3 percent over the long run. Indeed, the level of intelligence is not high enough to foster appreciably faster growth over time. As I like to ask the question, why did it take so long to recognize the economic value of silicon among other things or to appreciate the desirability of reorganizing corporate structures the way businesses do now? Business firms could have done that fifty years ago, and they didn’t. The answer is that we’re just not smart enough. The reason that a lot of the emerging nations are able to sustain faster economic growth is that they are catching up. It’s not an intelligence issue. So there is something here that has to change, or we really are looking at a new trend in productivity that, as I see it, is remarkably fundamental. My impression of the employment data is that the probability of a significant upward revision in the December number or a pop in the January number is a good deal better than 50/50. And I would submit that, as of next week, we may—I say “may”—be looking at a somewhat different overall picture of the labor market.

The question that we have to ask ourselves is, What could go wrong with this extraordinary scenario, which the Board’s staff forecast extends through 2005? It involves the most extraordinary and benign economic performance that I have observed in my business lifetime. But then again all this involves a productivity world that I’ve never perceived or lived in, and it may be more real, if I may put it that way, than we imagine.

There are several developments, however, that I find worrisome. All have been mentioned in our discussion. The first is that yield spreads continue to fall. As yield spreads fall, we are in effect getting an incremental increase in risk-taking that is adding strength to the economic expansion. And when we get down to the rate levels at which everybody is reaching for yield, at some point the process stops and untoward things happen. The trouble is, we don’t know what will happen except that at these low rate levels there is a clear potential for huge declines in the prices of debt obligations such as Baa-rated or junk bonds. To put it another way, the potential snapback effects are large. We are always better off if equity premiums are moderate to slightly high or yields are moderate to slightly high because the vulnerability to substantial changes in market psychology is then obviously less. In my view we are vulnerable at this stage to fairly dramatic changes in psychology. We are undoubtedly pumping very considerable liquidity into the financial system. It is showing up in the Goldman Sachs and Citicorp indicators. We don’t see it in the money supply numbers or some other standard indicators. We’re seeing it in the asset-price structure. That structure is not yet at a point where “bubble” is the appropriate word to describe it, but asset pricing is getting to be very aggressive. I don’t know whether any of you have noticed that, while stock market prices have been rising persistently since March of last year, the rise in the last four or five weeks has been virtually straight up. That’s usually a sign that something is going to change and that the change is usually not terribly helpful.

I think we have to be wary of the possibility of a somewhat different outcome than is suggested by the model we may be looking at. The main issue here is what will happen in the event of a decline in the rate of growth in output per hour. In the context of the strength in aggregate demand that we are experiencing, we should get a big surge in employment. We should also get, as the staff forecast suggests, the first significant increases in unit labor costs. It is not price that we ought to be focusing on. It is not core PCE, although I think that’s ultimately where we’re going. The first signs of emerging trouble are likely to be in the form of increases in unit labor costs; and with profit margins currently at high levels, those increases may be absorbed for a while in weaker profit margins, which is probably not a bad forecast at this stage. But there is also a difficult question regarding what has caused the decline in inflation in recent years. It has been global and not confined to the United States, and it cannot simply be the consequence of monetary policy. I realize that a lot of people think that world monetary policy has suddenly gotten terrific and that it is the reason for the global decline in inflation. I’d love to believe that is true. I don’t believe it for four seconds. I think that what we’re looking at is, to an important extent, the consequence of a major move toward deregulation, the opening up of markets, and strong competitive forces driven in large part by technology. I don’t know how long this very significant downward pressure on prices is going to last. With regard to deregulation, I do know that the lowering of trade barriers is coming to a halt. All of the low- hanging fruit involved in trade negotiations has probably been picked, and we will be very fortunate if we can just stabilize the situation here without experiencing a rise in protectionism.

There has been a lot of discussion about the gap issue here, and I think for good reason as Ben Bernanke and Bill Poole have indicated. I might add that random walk does not mean that the inflation in 2004 is necessarily going to be the same as in 2003. That’s the expected value, but the outcome could very easily be 1½ points higher under foreseeable circumstances. What I think we have to ask ourselves is which of the various alternatives for policy can give us the most significant trouble if we are wrong. In that regard my judgment is that the expected value of inflation is in the area of its current level as far out as I can see. I also think that if we wanted to retain the “considerable period” language, we would be able to do that for a significant period of time. Indeed, I would guess that the most likely forecast of when we will have to move is not too far from when the futures market is currently anticipating that move will occur. We need to remember that we are talking very largely about a move in a tightening direction. There is a small probability that we might have to move rates lower should we suddenly run into some deflationary problems. That in my judgment is a very small probability, but it is not zero.

We are, therefore, essentially looking at the question of doing nothing or tightening. In that regard, the most costly mistake would be for us to be constrained by the “considerable period” phraseology at a time when inflationary pressures were building up fairly rapidly. If the probability that we will have to drop the “considerable period” reference is very high, which I think it is, it’s not clear to me what we gain by waiting. If, indeed, the economy is as buoyant as the discussion around this table has just described, then we are going to be pressed relatively quickly by market developments to start moving. In that event, the futures bulge now ten months out would very likely start to move closer in time. I don’t think that’s the most probable outcome, but it is a sufficiently large part of the probability tail to suggest to me that we ought to drop the “considerable period” language and adopt some reference to “patience.” The latter would in my view give us greater leeway to take action. We probably will also have to tack against the amount of liquidity that we’re pumping into the financial system. As Governor Gramlich rightly mentioned, it’s probably wise to call in the fire engines.

It’s one thing to look at the degree of liquidity after rates have been this low for this long and another to presume that the structure of the economy is going to stay this way if we continue to hold rates at this level for, say, another year and a half. So my view as far as policy is concerned is that it would not be a bad thing if we referred in some way to “patience” rather than to “considerable period” in our press statement and the markets responded in a negative way by moving up funds rate futures and long-term bond yields. Unless what I’ve heard this morning about business conditions and business sentiment is going to be dramatically reversed by the time of the next meeting, interest rates are too low. One may ask how that can be because a large number of market participants are aware of all these developments and in the past they presumably would have moved market rates higher by now. I would suggest that there is a very significant danger that they have listened to us! [Laughter] We have convinced them that the earlier simplistic view of our response to an upturn in economic growth and the associated risk of rising inflation does not apply under prevailing circumstances and will not lead us to tighten monetary policy in the near term. We have succeeded in demonstrating that such a view was now wrong. When we first argued that it was wrong, they didn’t believe us. We argued again, and they said, “Well, maybe.” We continued to argue that they were wrong, and they now believe us.

One implication in my judgment is that we can’t necessarily look, for example, at a chart showing the one-year maturity for the ten-year Treasury note nine years out, which is trading steadily at a little over 6 percent, and say that the market does not expect a rise in inflation. That may be what the numbers tell us. What I don’t know is whether that chart is based on market factors or whether I’m looking in a mirror. And I fear that it’s more the latter than the former. It is a terrific vote of confidence in the System or what Al Broaddus likes to call our credibility, but I’m not sure that we’re wise to sit here and allow that view to persist if indeed that is the case.

As a consequence and in line with our discussions at this and previous meetings regarding the desirability of taking gradual steps, I think today is the day we should adjust our press statement and move to a reference to “patience.” I think the downside risks to that change are small. I do think the market will react “negatively” as we used to say, but I’m not sure such a reaction would have negative implications, quite frankly. If we were to retain the “considerable period” wording, I would hate to find us in the position of seeing Citicorp’s forecast of a 300,000 increase in January employment number actually materialize in next week’s announcement. We would be in a very uncomfortable position. If we go to “patience,” we will have full flexibility to sit for a year or to move in a couple of months. I don’t think we’re going to want to do the latter, but I’d certainly like to be in that position should a rate increase become necessary. That’s my view. Who’d like to comment? Governor Kohn.

Greenspan doesn’t think the economy is in a bubble.

Greenspan is not sounding the alarm.

Greenspan does not even want to raise the Fed Funds rate above 1%/year. Greenspan wants “patience”.

Greenspan is painting a picture of an extraordinary “degree of buoyancy…. Committee members have not reported on indications of a more unequivocally benign and positive economic outlook in a number of years…” The “back in the late 90s” is not Greenspan saying “this is another bubble”–Greenspan says, explicitly, that “bubble” is “not yet… the appropriate word”. It is, rather, an assessment that the economy is currently performing well. After giving that assessment, Greenspan then segues to considering tail risks: saying “the outlook seems extraordinarily benign, and I’ll get to the reasons why that bothers me shortly”. That’s where the “snap-back” phrase comes from.

So Mallaby’s basic thesis–that Greenspan believed in January 2004 that the economy was in a dangerous bubble and on the edge of catastrophe–is directly falsified by a five-minute look at the document from which Mallaby got the two phrases he quotes.

Mallaby continues:

Of course, this begs a question: If Mr. Greenspan understood the danger of bubbles, why did he nonetheless permit them–even rationalizing his policy with a public insistence that the best way to deal with bubbles was to clean up after they burst?…

Since Greenspan did not understand the dangers in the mid-2000s, Mallaby is asking a false question. He then gives an answer to his false question, and it is an answer that would be greatly to Greenspan’s discredit, were it to be true:

Most of the explanation lies in the political environment…. Greenspan was a hardened Washington veteran… calculated that acting forcefully against bubbles would lead only to frustration and hostile political scrutiny. And his caution was vindicated. When he did try to rein in risk-taking—calling, for example, for restraints on the government-sponsored housing lenders—he felt the heat. The housing-industrial complex denounced him for failing to understand mortgage finance and ran devastating TV ads to deter members of Congress from supporting Mr. Greenspan’s calls for regulatory intervention.

As Mallaby paints the picture, Greenspan didn’t do what he clearly knew to be his clear job. Why not? Because he “felt the heat”. Because he was “denounced for failing to understand mortgage finance”. Plus there were those “devastating TV ads”!

All this is to set up Mallaby’s conclusion as to who are the real culprits here:

It is too easy, and too comforting, to blame Alan Greenspan’s supposed intellectual errors for the 2008 crisis…. The origins of the crisis lay not in the maestro’s failure of understanding–which would be easy to correct. Rather, it lay in the failure of our politics. Who in this electoral season would bet that we are safer now?

But this is wrong: Alan Greenspan made a bad call in the mid-2000s. Alan Greenspan was never a coward.

Must-Read: Sebastian Mallaby: The Doubts of Alan Greenspan

Posted on by Brad DeLong

Must-Read: WTF?! I see Sebastian Mallaby, apparently thinking he is defending Alan Greenspan’s reputation.

He is not: he is making Greenspan appear a really bad actor indeed.

He is making Greenspan appear to be somebody who knew the dangers of the housing bubble in the mid-2000s, and let the risk of a little political heat–“devastating TV ads…”–dissuade him from doing his job.

Needless to say, I think Mallaby is way wrong here:

Sebastian Mallaby: The Doubts of Alan Greenspan:

In Jan. 2004, with house prices starting to look frothy, Mr. Greenspan repeated his warning, predicting a repeat of the tech bust…

…“It sounds as though we’re back in the late ’90s,” he worried to his colleagues. “The potential snap-back effects are large.”… Long before the 2008 crisis, he had understood the lessons that were celebrated as new insights in the wake of the crash. Of course, this begs a question: If Mr. Greenspan understood the danger of bubbles, why did he nonetheless permit them—even rationalizing his policy with a public insistence that the best way to deal with bubbles was to clean up after they burst?…

The political environment…. Greenspan was a hardened Washington veteran…. He calculated that acting forcefully against bubbles would lead only to frustration and hostile political scrutiny. And his caution was vindicated. When he did try to rein in risk-taking—calling, for example, for restraints on the government-sponsored housing lenders—he felt the heat. The housing-industrial complex denounced him for failing to understand mortgage finance and ran devastating TV ads to deter members of Congress from supporting Mr. Greenspan’s calls for regulatory intervention.

It is too easy, and too comforting, to blame Alan Greenspan’s supposed intellectual errors for the 2008 crisis…. The origins of the crisis lay not in the maestro’s failure of understanding–which would be easy to correct. Rather, it lay in the failure of our politics. Who in this electoral season would bet that we are safer now?

How Seriously Should We Take the New Keynesian Model?

Posted on by Brad DeLong
Calvo pricing Google Search

Nick Rowe continues his long twilight struggle to try to take the New Keynesian-DSGE seriously, to understand what the model says, and to explain what is really going on in the New Keynesian DSGE model to the world. I said that I think this is a Sisyphean task. Let me expand on that here:

Now there is a long–and very successful–tradition in the natural sciences of taking the model that produces the right numbers seriously. Max Planck introduced a mathematical fudge in order to fit the cavity-radiation spectrum. Taking that fudge seriously produced quantum mechanics. Maxwell’s equations produced equivalent effects via two very different physical processes from moving a wire near a magnet and moving a magnet near a wire. Taking that equivalence seriously produced relativity theory.

And economists think they ought to be engaged in the same business of taking what their models say seriously. They shouldn’t. For one thing, their models don’t capture what is going on in the real world with any precision. For another, their models’ fudge factors lack hooks into possible underlying processes.

Now to business:

In the basic New Keynesian model, you see, the central bank “sets the nominal interest rate” and that, combined with the inflation rate, produces the real interest rate that people face when they use their Euler equation to decide how much less (or more) than their income they should spend. When the interest rate high, saving to spend later is expensive and so people do less of it and spend more now. When the interest rate is low, saving to spend later is cheap and so people do more of it and spend less now.

But how does the central bank “set the nominal interest rate” in practice? What does it physically (or, rather, financially) do?

¯_(ツ)_/¯

In a normal IS-LM model, there are three commodities:

  1. currently-produced goods and services,
  2. bonds, and
  3. money.

In a normal IS-LM model, the central bank raises the interest rate by selling some of the bonds it has in its portfolio for cash and burns the cash it thus collects (for cash is, remember, nothing but a nominal liability of the central bank). It thus creates an excess supply (at the previous interest rate) for bonds and an excess demand (at the previous interest rate) for cash. Those wanting to hold more cash slow down their purchases of currently-produced goods and services (thus creating an excess supply of currently produced goods and services) and sell some of their bonds (thus decreasing the excess supply of bonds). Those wanting to hold fewer bonds sell bonds for cash. Thus the interest rate rises, the flow quantity of currently-produced goods and services falls, and the sticky price of currently-produced goods and services stays where it is. Adjustment continues until supply equals demand for both money and bonds at the new equilibrium interest rate and at a new flow quantity of currently produced goods and services.

In the New Keynesian model?…

Nick Rowe: Cheshire Cats and New Keynesian Central Banks:

How can money disappear from a New Keynesian model, but the Central Bank still set a nominal rate of interest and create a recession by setting it too high?…

Ignore what New Keynesians say about their own New Keynesian models and listen to me instead. I will tell you how it is possible…. The Cheshire Cat has disappeared, but its smile remains. And its smile (or frown) has real effects. The New Keynesian model is a model of a monetary exchange economy, not a barter economy. The rate of interest is the rate of interest paid on central bank money, not on bonds. Raising the interest rate paid on money creates an excess demand for money which creates a recession. Or it makes no sense at all.

I will take “it makes no sense at all” for $2000, Alex…

Either there is a normal money-supply money-demand sector behind the model, which is brought out whenever it is wanted but suppressed whenever it raises issues that the model builders want ignored, or it makes no sense at all…

Must-Read: Paul Krugman: A General Theory Of Austerity?

Posted on by Brad DeLong

Must-Read: Paul Krugman: A General Theory Of Austerity?:

as someone who was in the trenches during the US austerity fights, I was struck by how readily mainstream figures who weren’t especially right-wing in general got sucked into the notion that debt reduction was THE central issue. Ezra Klein documented this phenomenon with respect to Bowles-Simpson:

For reasons I’ve never quite understood, the rules of reportorial neutrality don’t apply when it comes to the deficit. On this one issue, reporters are permitted to openly cheer a particular set of highly controversial policy solutions. At Tuesday’s Playbook breakfast, for instance, Mike Allen, as a straightforward and fair a reporter as you’ll find, asked Simpson and Bowles whether they believed Obama would do “the right thing” on entitlements — with “the right thing” clearly meaning “cut entitlements.”

Meanwhile, as Brad Setser points out, the IMF — whose research department has done heroic work puncturing austerity theories and supporting a broadly Keynesian view of macroeconomics — is, in practice, pushing for fiscal contraction almost everywhere.

Again, this doesn’t exactly contradict Simon’s argument, but maybe suggests that there is a bit more to it.

Must-Read: Temina Madon, Karen J. Hofman, Linda Kupfer, and Roger I. Glass: Implementation Science

Posted on by Brad DeLong

Must-Read: Temina Madon, Karen J. Hofman, Linda Kupfer, and Roger I. Glass: Implementation Science:

We face a formidable gap between innovations in health… and their delivery….

Nearly 14,000 people in sub-Saharan Africa and South Asia die daily from HIV, malaria, and diarrhea…. Many evidence-based innovations fail to produce results when transferred to communities… because their implementation is untested, unsuitable, or incomplete…. Insecticide-treated bed nets can prevent malaria… yet… fewer than 10% of children in 28 sub-Saharan African countries regularly slept with this protection…. The same is true of strategies to prevent mother-to-child transmission of HIV….

Why is effective implementation, particularly in resource-poor countries, such an intractable problem?… Scientists have been slow to view implementation as a dynamic, adaptive, multiscale phenomenon that can be addressed through a research agenda…. People living in poverty face a bewildering constellation of social constraints and health threats…. Recent billion-dollar increases in budgets for global health have provided only limited support for studies needed to ensure maximum impact. Instead, planners often assume that clinical research findings can be immediately translated into public health impact, simply by issuing “one-size-fits- all” clinical guidelines or best practices without engaging in systematic study of how health outcomes vary across community settings…

Must-Read: Robert Skidelsky: The Scarecrow of National Debt

Posted on by Brad DeLong

Must-Read: Robert Skidelsky: The Scarecrow of National Debt:

Most people are more worried by government debt than about taxation…

Borrowing strikes them as a way of taxing by stealth. “How are they going to pay it back?” my friend asked. “Think of the burden on our children and grandchildren.”… Horror of debt is particularly marked in the elderly, perhaps out of an ancient feeling that one should not meet one’s Maker with a negative balance sheet. I should also add that my friend is extremely well educated, and had, in fact, played a prominent role in public life. But public finance is a mystery to him….

One should not attribute this gut feeling to financial illiteracy. It has been receiving strong support from those supposedly well-versed in public finance, particularly since the economic collapse of 2008. Britain’s national debt currently stands at 84% of GDP. This is dangerously near the threshold of 90% identified by Harvard economist Kenneth Rogoff, beyond which economic growth stalls.

The magical properties of this number were never properly revealed, and the data supporting the conclusion were questioned, to say the least. But Rogoff has not retreated from his claim, and he now gives a reason for his alarm. With US government debt running at 82% of GDP, the danger is of a “fast upward shift in interest rates.” The “potentially massive” fiscal costs of this could well require “significant tax and spending adjustments”… the financial leg of the familiar “crowding out” argument….

But… a government that can issue debt in its own currency can easily keep interest rates low. The rates are bounded… [but] these limits are quite distant in the UK and the US…. Continuous increases in both countries’ national debt since the crash have been accompanied by a fall in the cost of government borrowing to near zero. The other leg of the argument for reducing the national debt has to do with the “burden on future generations.”… The idea that additional government spending, whether financed by taxation or borrowing, is bound to reduce private consumption by the same amount assumes that no flow of additional income results from the extra government spending – in other words, that the economy is already at full capacity. This has not been true of most countries since 2008.  
 
But in the face of such weighty, if fallacious, testimony to the contrary, who am I to persuade my elderly friend to ignore his gut when it comes to thinking about the national debt?