Talking Points: Global Cross-Fire: Secular Stagnation or Policy Paralysis?

1. “Secular stagnation” is a misleading phrase. It was coined by Alvin Hanson in the 1930s to describe a fear that an exhaustion of technological opportunities in a world monetary system that still possessed a nominal anchor to gold would generate a sub-zero full-employment Wicksellian natural rate of interest. But we don’t have an exhaustion of technological opportunities. We don’t have a monetary system with a nominal anchor to gold.

2. What we do have are rates of inflation in the DMs that expose us to severe downside macroeconomic risks, and a lack of risk tolerance and risk-bearing capacity in the United States that keep even the lowest of attainable safe interest rates from producing high enough equity and capital valuations to make it profitable to boost investment enough to push DM economies to anything like full employment.

3. There have not yet been any convincing stories of how a trend growth drop would have emerged in the absence of the investment shortfall, the labor skills atrophy, and the other channels of “hysteresis” that have been in operation since 2008.

4. The only major supply shock in the past decade has been a positive one: the unexpected emergence of new hydrocarbon-extraction technologies like tracking. We could have a large adverse hydrocarbon-supply shock from political turmoil at the borders of Muscovy. But we have not yet.

5. What to expect from interest rates? They will, of course, fluctuate. The modal scenario I see in the United States is one in which the Federal Reserve begins raising interest rates too early–a la Sweden at the start of this decade–and then has to return to the ZLB in a year or two as the economy weakens. The optimistic scenario is that that of the smooth glide-path to the normalized, Goldilocks economy. The pessimistic scenario is another adverse shock hits demand while the Federal Reserve is still too close to the ZLB to effectively respond, and political gridlock gives the United States another lost decade.

6. What to expect from interest rates? They will, of course, fluctuate. The modal scenario I see in the Eurozone is one of continued waves of crisis as Eurozone breakup fears cause spikes in interest rates in the European periphery, as the ECB then does enough to calm markets but not enough to generate recovery, that Germany makes covert fiscal transfers to keep the pain low enough to keep the Eurozone together–and winds up spending much much more than if it had bit the bullet back in 2000. In that scenario German growth over the medium term remains at best adequate as the chronic Eurozone crisis both diminishes confidence and keeps German exports competitive.

7. The pessimistic scenario is one of Eurozone breakup–with German interest rates even lower than they are, and peripheral European interest rates high with redoubled risk premium. The optimistic scenario is that somehow, some way, the Confidence Fairy appears and the Eurozone has a smooth glide-path to a normalized, Goldilocks economy.

8. The source of the chronic crisis is a shortage of aggregate demand coupled with deep structural woes that originated in the decision by German banks to loan massive amounts to the Eurozone periphery. Those loans pushed costs in the Eurozone periphery up to levels that are in strong disequilibrium in the absence of continued capital outflows from Germany.

9. Since the chronic crisis had a German origin–in the lending decisions of German banks–it is only appropriate that it have a German solution–adjustment via German fiscal expansion and via the implicit real debt writedowns generated by moderate German inflation should be part of the solution.

10. Back in 1829, the young British economist John Stuart Mill was the first to argue that the market monetary economy there would not be enough spending to employ everyone who could be profitably employed at the wages they demanded if and only if the economy lacked enough cash and cash-like assets to make households, businesses, and savers as a group happy with their holdings of means of payment and potential collateral.

11. The provision of those cash and cash-like assets has to be the business of the national or currency-area government–if not of a super-continental monetary and financial hegemon–because no private entity has the power to make its liabilities legal tender and thus the ability to guarantee their acceptance in transactions and as collateral.

12. The ECB is tasked with this Millian objective of providing the eurozone economy with the means of payment and stores of value–cash and potential collateral–that the economy needs. The ECB is failing.

13. Fourth quarter-to-fourth quarter real GDP growth in the eurozone in 2013 was 0.5%. Fourth quarter-to-fourth quarter real GDP growth in the eurozone in 2013 looks to be 0.4%. December-to-December inflation in the eurozone in 2013 was 0.9%. December-to-December inflation in the eurozone in 2014 looks to be 0.0%. The ECB’s annual inflation target is 1.75%. Given the potential for catchup in the European periphery to higher productivity standards, that can only be attained via nominal eurozone GDP growth of 4%-5%/year. The 1.4% nominal GDP growth we saw in 2013 and the 0.4% nominal GDP growth it appears we will see in 2014 tell us that the ECB has fallen further behind the curve than it was at the end of 2012: 7.2%-points further behind the curve than it was then.

14. One possibility is that the ECB is failing because it cannot do so, for every time it creates a reserve deposit it does so by withdrawing A high-quality liquid asset from the private market place, and so to first-order leaves the stock of cash plus potential collateral unchanged. Perhaps the ECB cannot carry out its million objective without engaging in what would be regarded as fiscal policy.

15. Another possibility is the ECB is failing because financial Germany believes that the ECB’s target must be not a 1.75%/year inflation target for the eurozone, but a 1.5%/year or less inflation target for Germany–and that Mario Draghi is not powerful enough to overrule financial Germany in the corridors of power in the ECB and hence cannot do whatever it takes.

16. In this context, I am reminded of Ludger Schuknecht’s exchange with Martin Wolf back in 2012, in which Schuknecht said, among others things: “Mr Wolf’s solution… is risk transfer via eurobonds… and demand stimulation via cheaper money and less fiscal consolidation in Germany. But the public and markets have been led to believe in short-­term measures for far too long….” “expansionary policies and weak fiscal positions… created the current problems…” “fiscal consolidation and structural reforms… have invariably succeeded wherever they have been implemented…” “any decision to disregard the rules or introduce ill­-suited tools such as eurobonds could undermine… confidence…” “Germany must not undermine its role as an anchor of stability via inappropriate and ineffective fiscal stimuli…” “German and European interests are indeed very much aligned and they are reflected in the jointly agreed strategy…”: the policies that the eurozone has undertaken over the past 2.5 years were, to his eyes back in 2012, already dangerously radical and already pushing the utmost of the envelope that Germany could allow. Yet now we clearly need more…

Must- and Shall-Reads:

• Andy Dubbin: As sea level rises, so does money spent denying it
• The Oatmeal: Christopher Columbus was awful (but this other guy was not)
• John Podesta: Deficit anxiety is not the answer. Here’s what America needs to do
• Clay Shirky: Publishing and Reading
• Bo Rothstein and Eric Uslaner: All for One: Equality, Corruption, and Social Trust
• Daniel Davies: A Disquisition on the Nature of Debt
• Barry Eisler: The Heart of the Matter: Franklin Foer: “Stop Amazon, Keep Publishing Exactly As It’s Always Been!”
• Nick Rowe: Helicopters, redemption, and the target
• Brooke Masters: Satya Nadella’s bad karma over remarks on women’s pay

1. Daniel Davies: A Disquisition on the Nature of Debt: “Debt… is a promise to pay back a specific amount of money at a specific time. Why is it so popular–why do people always seem to end up getting into it? Why, for example, don’t people make more equity investments?… Debt has one big advantage… the same advantage that market economies have over command economics–it’s really really efficient in terms of the amount of information that people need to gather about each other. If you’re lending money under a debt contract, all you need to think about is ‘Do I think this guy is good for the money?’, and all the borrower needs to think about is ‘Can I pay this back?’. If you’re trying to make an investment and share the risks, all sorts of other questions come into play: ‘How much could this be worth in a really good outcome? What further projects might grow out of this one? What effect will the sharing of the upside and downside have on the way the thing is managed? Am I selling my shares too cheap?…. David Graeber wrote a whole gigantic book, one of the messages of which was that from an anthropological view, debt contracts denatured exchange relationships and took them out of their context of cultural human interactions, but in my review, I noted that Graeber didn’t seem to appreciate the extent to which this is a collossal time saver…. And this even extends into credit analysis. I once calculated, to win a bet… that… if banks were to carry out a full credit assessment on all of their counterparties every time they incurred a new exposure then this would take up all of the time of every Chartered Financial Analyst ever to have got the qualification, doing nothing other than these credit checks. It’s literally impossible for the system to work without a degree of blind faith that most credits are money-good. The conclusion… is that… from both the banks’ and Greece’s point of view, these weren’t bad loans–they were good loans which went bad…. All of which isn’t to say that the banks deserved to get paid back, quite the opposite… the 70% writedowns that they took should… be regarded as… just punishment…. Everyone made decisions just as bad as the Greeks, but as I say, Greece was less able to deal with the consequences…”

2. Barry Eisler: The Heart of the Matter: Franklin Foer: “Stop Amazon, Keep Publishing Exactly As It’s Always Been!”: “If Foer wants to claim Amazon is a ‘monopoly’, that’s just routine thoughtlessness…. But then he goes on to make a claim that can only be the product of shocking ignorance or brazen deceit: ‘That term [monopoly] doesn’t get tossed around much these days, but it should.’ Holy shit, ‘Amazon is a monopoly’ doesn’t get tossed around much these days?! Did Foer even read the George Packer piece he cites?…Has he read David Streitfeld in the New York Times, or Laura Miller in Salon?… Just Google “Amazon Hachette Monopoly” and see what you come up with. I see three general possible explanations for Foer’s remarkably inaccurate claim: 1.  Foer is embarrassingly ignorant…. 2. Foer is aware of how hoary the ‘Amazon is a monopoly’ meme has become… but doesn’t want to admit he has nothing new to say…. 3.  Foer is aware of how hoary the ‘Amazon is a monopoly’ meme has become, but believes no other activist… has been sufficiently alarmist… is adequately conveying just how terrifying it all is. 4. Foer… also knows you can lend an air of false gravitas to bogus claims and conspiracy theories by implying the mainstream media is too cowed to Speak The Truth…. Really, is it possible to write a 3000-word article–with references to articles that themselves claim Amazon is a monopoly–and genuinely believe ‘the term monopoly doesn’t get tossed around much these days’?… The tendentiousness in Foer’s argument isn’t even what’s most interesting about it. What’s implicit is even more so: that it would actually be bad if more people could afford to buy books by Salman Rushdie and Jennifer Egan. How is this view any different from the arguments that must have been made against the Vulgate Bible, or the Guttenburg printing press? ‘Tsk, isn’t this just going to make reading more accessible to the unwashed masses?’ If you haven’t read it already, I can’t recommend highly enough this article by Clay Shirky about the aristocratic, elitist, narcissistic worldview always inherent in the minds of people like Foer…”

3. Nick Rowe: Helicopters, redemption, and the target: “What makes helicopter money truly helicopter money… is the announced increase in the price level target or NGDP level path target that accompanies the helicopter. ‘Helicopter money’ with no change in the target is not like Willem Buiter’s helicopter money, because that extra ‘helicopter money’ will need to be redeemed at some (unknown) time in the future, at the same future price level as before, and so the ‘helicopter’ increases the real value of government liabilities. Furthermore, if the central bank announces an increase in the NGDP level path target, that reduces the real value of government liabilities, and this converts some of the previously existing money into helicopter money ex post facto. You don’t need the helicopter. If the government halves Pm, it converts half the money that already exists into helicopter money…”

4. Brooke Masters: Satya Nadella’s bad karma over remarks on women’s pay: “It is hard to believe he would have said the same thing to a man…. At Facebook, they lean in. At Microsoft, they lean out. This week, when Satya Nadella, chief executive of the Redmond, Washington-based software group, faced a question about what women should do to be paid more, he firmly stuck both feet in his mouth. ‘It’s not really about asking for the raise, but knowing and having faith that the system will give you the right raises as you go along’, he said, adding that such patience was ‘good karma’.”

Should Be Aware of:

• Arthur I. Miller: Imagery in Scientific Thought
• Daniel Davies: “I can work out Greek words phonetically, as long as they stick to using letters that are also the names of important physical constants or option pricing parameters. And once you’ve worked out the transliteration, most of the stuff that’s on billboards or menus is going to sound like either the English word or the French one or the Italian one.”

1. Matt O’Brien: Uh-oh, the credit rating agencies are up to their old tricks again: “As far as financial crisis villains go, the credit rating agencies never get enough, well, credit. But now they’re reminding us that even—or especially—nincompoops can blow up the global economy when you play them off against each other with the promise of a quick buck…. It was dumb enough to create a system that encourages the credit rating agencies to take a Panglossian view of the bonds they’re supposedly rating. It’d be even dumber to leave it in place after we’ve seen what a disaster it is.”

2. Dara Lind: This immigration program drove a state official to suicide. It could give Dems the Senate: “One of the insane and convoluted subplots in South Dakota’s insane and convoluted Senate race — which could be the race that decides which party controls the Senate after Election Day — is a scandal involving the Republican candidate, Mike Rounds, who’s the former governor of the state. The scandal became public last fall, after one of Rounds’s former cabinet officials committed suicide. It turned out that he was facing a likely indictment for “diverting” (i.e., stealing) $550,000 in state funds when he killed himself. Since then, dribs and drabs of information have come out about massive conflicts of interest in the way Rounds’ administration administered its EB-5 visa program, an obscure initiative that is designed to attract foreign capital to the United States but which is often criticized as an open invitation to corruption. Most recently, it came out last week that Rounds had actually been named in a lawsuit that one visa recruiter filed against the state — even though Rounds had been saying he was not involved. The saga involves a failed beef plant, some shady public-private partnerships and millions of dollars pocketed from foreign investors. But at its center is the EB-5 visa — which lets immigrants come to the US and get green cards for putting hundreds of thousands of dollars into US businesses.”

3. Mohamed A. El-Erian: Why Is the Fed Thinking Globally?: “Outside of crisis periods — and we aren’t in one — the U.S. Federal Reserve normally behaves and speaks as if the U.S. is essentially a closed economy. Not so at its last policy meeting. The minutes released this week contain an unusual focus on both the world economy and the value of the dollar; and the drivers are a mix of old and new — at least they should be…”

• Weekend Reading: Daniel Davies: A Disquisition on the Nature of Debt: “Debt… is a promise to pay back…

…a specific amount of money at a specific time. Why is it so popular–why do people always seem to end up getting into it? Why, for example, don’t people make more equity investments?… Debt has one big advantage… the same advantage that market economies have over command economics–it’s really really efficient in terms of the amount of information that people need to gather about each other. If you’re lending money under a debt contract, all you need to think about is ‘Do I think this guy is good for the money?’, and all the borrower needs to think about is ‘Can I pay this back?’. If you’re trying to make an investment and share the risks, all sorts of other questions come into play: ‘How much could this be worth in a really good outcome? What further projects might grow out of this one? What effect will the sharing of the upside and downside have on the way the thing is managed? Am I selling my shares too cheap?…. David Graeber wrote a whole gigantic book, one of the messages of which was that from an anthropological view, debt contracts denatured exchange relationships and took them out of their context of cultural human interactions, but in my review, I noted that Graeber didn’t seem to appreciate the extent to which this is a collossal time saver…. And this even extends into credit analysis. I once calculated, to win a bet… that… if banks were to carry out a full credit assessment on all of their counterparties every time they incurred a new exposure then this would take up all of the time of every Chartered Financial Analyst ever to have got the qualification, doing nothing other than these credit checks. It’s literally impossible for the system to work without a degree of blind faith that most credits are money-good. The conclusion… is that… from both the banks’ and Greece’s point of view, these weren’t bad loans–they were good loans which went bad…. All of which isn’t to say that the banks deserved to get paid back, quite the opposite… the 70% writedowns that they took should… be regarded as… just punishment…. Everyone made decisions just as bad as the Greeks, but as I say, Greece was less able to deal with the consequences…

Barry Eisler: Franklin Foer: “Stop Amazon, Keep Publishing Exactly As It’s Always Been!”: “Then he goes on to make a claim that can only be the product of shocking ignorance or brazen deceit: ‘That term [monopoly] doesn’t get tossed around much these days, but it should.’ Holy shit, ‘Amazon is a monopoly’ doesn’t get tossed around much these days?! Did Foer even read the George Packer piece he cites?…Has he read David Streitfeld in the New York Times, or Laura Miller in Salon?… Just Google “Amazon Hachette Monopoly” and see what you come up with. I see three general possible explanations for Foer’s remarkably inaccurate claim: 1.  Foer is embarrassingly ignorant…. 2. Foer is aware of how hoary the ‘Amazon is a monopoly’ meme has become… but doesn’t want to admit he has nothing new to say…. 3.  Foer is aware of how hoary the ‘Amazon is a monopoly’ meme has become, but believes no other activist… has been sufficiently alarmist… is adequately conveying just how terrifying it all is. 4. Foer… also knows you can lend an air of false gravitas to bogus claims and conspiracy theories by implying the mainstream media is too cowed to Speak The Truth…. Really, is it possible to write a 3000-word article–with references to articles that themselves claim Amazon is a monopoly–and genuinely believe ‘the term monopoly doesn’t get tossed around much these days’?…

The tendentiousness in Foer’s argument isn’t even what’s most interesting about it. What’s implicit is even more so: that it would actually be bad if more people could afford to buy books by Salman Rushdie and Jennifer Egan. How is this view any different from the arguments that must have been made against the Vulgate Bible, or the Guttenburg printing press? ‘Tsk, isn’t this just going to make reading more accessible to the unwashed masses?’ If you haven’t read it already, I can’t recommend highly enough this article by Clay Shirky about the aristocratic, elitist, narcissistic worldview always inherent in the minds of people like Foer.

Nick Rowe: Helicopters, redemption, and the target: “What makes helicopter money truly helicopter money…

…is the announced increase in the price level target or NGDP level path target that accompanies the helicopter. ‘Helicopter money’ with no change in the target is not like Willem Buiter’s helicopter money, because that extra ‘helicopter money’ will need to be redeemed at some (unknown) time in the future, at the same future price level as before, and so the ‘helicopter’ increases the real value of government liabilities. Furthermore, if the central bank announces an increase in the NGDP level path target, that reduces the real value of government liabilities, and this converts some of the previously existing money into helicopter money ex post facto. You don’t need the helicopter. If the government halves Pm, it converts half the money that already exists into helicopter money…

As I continue to try to worry–without great success–the question of just where the increases in financial instability produced by the prolonged period of past and expected future extremely low interest rates and by quantitative easing comes from…

Two sources of risk:

1. Sudden downward revisions in the expected future cash flows of underlying real assets that back financial assets.
2. Sudden upward revisions in the rate at which expected future cash flows are discounted.

To recap my thinking before now:

Over at Equitable Growth: Larry Elliott: IMF warns period of ultra-low interest rates poses fresh financial crisis threat: “The Washington-based IMF said…

…that… the risks to stability… c[o]me from the… shadow banking system… hedge funds, money market funds and investment banks that do not take deposits from the public. José Viñals, the IMF’s financial counsellor, said:

Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges…. Risks are shifting to the shadow banking system in the form of rising market and liquidity risks. If left unaddressed, these risks could compromise global financial stability.

The stability report said low interest rates were “critical” in supporting the economy because they encouraged consumers to spend, and businesses to hire and invest. But it noted that loose monetary policies also prompted investment in high-yield but risky assets and for investors to take bigger bets. One concern is that much of the high-risk investment has taken place in emerging markets, leaving them vulnerable to rising US interest rates…. The IMF said there was a trade-off between the upside economic benefits of low interest rates and the money creation process known as quantitative easing and the downside financial stability risks… developments in high-yielding corporate bonds were “worrisome”, that share prices in some western countries were high by historical norms, and that there were pockets of real estate over-valuation…

I have come to the conclusion that those who say that quantitative easing has increased systemic financial-market risks have simply not thought hard enough about what quantitative easing is. In quantitative easing the central bank takes duration risk off of the private sector’s balance sheet and onto the governments, that is, the taxpayers’. The ratio of risk to be borne to private-sector risk-bearing capacity falls. The presumption is that this makes financial markets less, not more, vulnerable to systemic risk. You could tell some kind of complex contrarian story with demand and supply curves that slope in non-obvious ways. But none of those who say that quantitative easing increases systemic risk make such arguments–and if they understood quantitative easing properly, they would understand that they need to and feel impelled to do so.

The argument that ultra-low interest rates and the anticipated continuation of ultra-low interest rates for a considerable time period raises systemic financial risks is less mired in the, well, mire. But it, too, is not obvious. An economy sinks into depression when households, savers, and businesses in aggregate believe that they are short of the assets they need to hold to ensure liquidity–that after subtracting off assets they are holding as savings vehicles they do not have enough cash and enough safe nominal assets that could be pledged to immediately raise cash. As a result, the aggregate of households, savers, and businesses try to cut their spending below their income in order to build up their liquid cash and safe collateral balances; but since my income is nothing more than your spending, they fail and so production, income, and spending fall until the private sector finds itself so poor that it no longer seeks to build up its liquid cash and safe collateral balances.

In such a situation the government, by trading its cash and its safe collateral liabilities for risky financial assets and four currently-produced goods and services both:

• creates more of what the private sector wants to hold, and so reduces or eliminates the gap between current and desired holdings of liquid cash and safe collateral.

• lowers interest rates and so increases the value of the future relative to the present, providing a direct financial incentive both to spend now on the creation of long-duration real assets and to spend now out of what are now more valuable anticipations of future income.

The first-order effects are on aggregate demand–are on resolving the disequilibrium excess demand for liquid cash and safe collateral that creates the gap between planned spending and expected income. The effects on financial stability are second-order. They are:

• On the one hand, higher asset valuations and higher levels of production and income greatly reduce the risks associated with financial assets backed by real wealth of one form or another.

• On the other hand, the tilting of the intertemporal relative price structure greatly increases the incentive to create long-duration financial assets–which will inherently be speculative, and some of which will partake to some degree of the unhedged out-of-the-money put or even the Ponzi nature.

• Which of these effects will be larger? For small reductions in interest rates, the first-order effect on the value of existing collateral assets in making finance safer will outweigh the second-order creation of new long-duration assets in making finance riskier.

• Which of these effects will be larger? To the extent that prudential regulation is effective–or even exists–the range over which reductions in interest rates will improve stability is larger.

• Which of these effects will be larger? To the extent that the economy is already flush with long-duration financial assets–which it is–the range over which reductions in interest rates will improve stability is larger.

The first-class study of this I know finds no evidence of the IMF’s contention that policies of ultra-low interest rates have laid the foundations for increased risks of systemic financial instability in the United States. Outside the United States? Yes, times of low interest rates in the core are times of opportunity–cheap financing is available to finance economic development–but also times of danger–are their financial markets robust enough to control and manage the hot-money fluctuations?–in the periphery. But how much weight does the argument that prudential policy in the periphery may go wrong have in militating against policies that–correctly–aim at appropriate internal balance in the core?

I am now more inclined to view worries that ultra-low interest rate and quantitative easing policies raise risks of future financial instability as the last-gasp argument of the austerians–as one more attempt to find an argument, any argument, to justify universal bankruptcy and the war on the Keynesian Mammon of Unrighteousness.

So should I rethink this?

In conversation, the wise young whippersnapper Gabriel Chodorow-Reich assigns me to the camp of the “institutions” view: that the danger is that systemically-important financial institutions become severely distressed; that conventional stimulative open-market operations give them more reserves to back loans; that stimulative quantitative easing takes duration risk off the private sector aggregate balance sheet; and neither of those obviously raises the risk that systemically-important financial institutions become severely distressed–rather the reverse, because without truly perverse demand curves systemically-important financial institutions should hold some of those increased reserves, and part with some of the assets with duration risk that quantitative easing takes off the table.

I agree with this characterization. As I see it, first-order risk is risk to the underlying, and the more QE, the less risky underlying the private-sector holds, and the more forward guidance, the larger the expected pool of reserve assets to keep financial institutions out of distress. Second-order risk is the risk not of a fall in underlying cash flows but of a big upward move in the market discount applied to risky cash flows–a sudden fall in the risk-tolerance of the market that overwhelms VAR limits. Why should QE that reduces the pool of risky assets and forward guidance that raises the expected pool of reserves raise the variance of risk-tolerance innovations. Third-order risk is when institutions reaching for yield have demand curves that slope the wrong way–the lower the spread, the more risky assets they hold. But this seems to require that QE and extended guidance have triggered an enormous wave of risky-asset issue if institutions are going to end with riskier portfolios.

But, he points out, there is also a “spreads” view, which as I interpret it seems to be:

• Long-term risky interest rates mean revert to normal.
• Stimulative monetary policy–present and expected future–lowers long-term risky interest rates.
• Quantitative easing lowers long-term risky interest rates too.
• Thus when long-term risky interest rates revert to their normal, they must undertake a larger jump.
• And that larger jump upon normalization causes greater losses and so creates more of a risk of severe financial distress.

And on this I have three thoughts:

I. It is not obvious to me what this “normal” that interest rates mean-revert to in the long run is. Looking at the nominal:

and at the real, with assumed adaptive inflation expectations:

perhaps you could argue for a 2.5%/year real Treasury 10-Year rate “normal” in the 1960s, and perhaps you could argue for a 3.75%/year real Treasury 10-Year rate “normal” from 1985-2000. But since 2000? Before 1980? And it is not at all obvious that the magnitude of the increase in long-term interest rates–nominal or real–in a business cycle recovery bears any relationship at all to the deviation from whatever you had previously thought of as “normal”.

The underlying argument really does seem to be: “expansionary policy, extended guidance, and quantitative easing have pushed long-term interest rates down below normal, and they are coming back to normal, and when they do come back they will come back one basis point for each basis point the Fed artificially pushed them down, and it will be bad.” The assumption seems to be either the policies are completely unwound–either by the Federal Reserve or by the market in some way–so that the Federal Reserve actions have no long-term permanent effect on the intertemporal price and risk structure and no medium-term transition-path effect on the speed of return to whatever the new normal turns out to be.

And I continue to find it impossible to put this argument into any kind of asset market demand and supply framework. And that makes me gravely suspicious.

There have been a number of arguments made in macroeconomics since 2006 that have been correct. There have been a number of arguments made in macroeconomics since 2006 that have been wrong but not implausible. And there have been a number of arguments–expansionary austerity; the 90% of annual GDP debt-limit cliff; quantitative easing necessarily and rapidly leading to debasement, de-anchoring of inflation expectations, and eventually hyperinflation, the zero fiscal multiplier–that seemed to me to be neither correct nor plausible but wrong but simply to lack any empirical or theoretical support whatsoever and to be the product of people who simply:

• had not done their homework,
• were grasping at straws for any argument that would support a previously-arrived at knee-jerk policy preference, and
• had very low intellectual standards.

The question is: what keeps the argument that quantitative easing and extended forward guidance are greatly increasing the risks of financial instability from falling into this third category? I am waiting for an answer. And I am not finding one.

In short, I am demanding that those who see quick unwinding of balance sheets and quick raising of interest rates as policies that would reduce rather than increase the risks of financial distress open up their black box and at least make an argument about what lies inside.

The stakes are large indeed. Let me turn over the microphone to the very smart Joe Gagnon:

Joe Gagnon: Yellen vs. the BIS: Whose Thesis Makes Better Sense?: “Janet Yellen is right to resist diverting monetary policy…

…from its primary objective of stabilizing economic activity and inflation: Everyone agrees that it is essential to fix the flaws in financial regulation and supervision… Governments need… to place limits on leverage and… raise capital standards. [But] setting monetary policy on any basis other than the stabilization of employment and inflation is more likely to harm financial stability than to help…. Even if it were clear that loose monetary policy feeds asset bubbles (and my colleague Adam Posen has argued convincingly that it is not), it does not follow that tighter monetary policy is necessarily the right response to a bubble. The damage caused by a bursting bubble arises from the deadweight costs of bankruptcy and the panic engendered…. The solution is to reduce debt and increase equity… and to ensure that systemically-important financial institutions are well capitalized.

During the housing bubble, restrictions on leverage needed to be tightened…. [But] to prevent the economy from falling into recession, the Fed would have needed to lower interest rates, not raise them, in order to encourage firms and households with healthy balance sheets to spend more. BIS economists point to historically low interest rates as a sign that policy is dangerously loose. However, there are many reasons why returns on safe instruments should be low or even negative now in real terms…. When the equilibrium required return on assets is at a historical low, then asset prices of necessity will be historically high. This does not imply that we are experiencing a risky bubble. Sweden recently provided a clear test of the dangers of diverting monetary policy from its primary function to fight a perceived bubble…. Its policy tightening may have been counterproductive even in terms of its original financial-stability motivation.

2234 words

Must- and Shall-Reads:

• Paul Krugman: In Defense of Obama
• Mario Draghi: Germany Should Start Spending More

1. Gavyn Davies: Germany Is Stalling: “Extremely weak German industrial production figures… for August have come an awkward time for the German government…. The official German line heading into these meetings is that the recovery is proceeding well, both in Germany and in the euro area as a whole, implying that the recent marked weakening in both GDP and inflation data is just a temporary aberration. There is no sign that the Merkel administration is ready to change its longstanding formula for economic success in the euro area: member states should stick to the fiscal targets in the Stability and Growth Pact, and should accelerate structural reforms, so that the expansionary monetary stance provided by the ECB can bear fruit…. This could change, however, if the German economy itself continues to weaken significantly. But how likely is this to happen?… The Fulcrum ‘nowcast’ models… activity growth rate has slowed from about 2.6 per cent in late 2013 to 0.9 per cent now…. It has not fallen yet into negative territory on an underlying basis, but it is certainly not acting as a powerful locomotive for the European economy. Far from it…. The Q2 official GDP growth rate of -0.6 per cent was already worse than had been expected…. The central estimate of the latest ‘nowcast’ for Q3 is that the GDP growth rate will rebound to 1.4 per cent annualised… about a 28 per cent probability [of a second negative number].”

2. Martin Wolf: An Extraordinary State of ‘Managed Depression’: “In the US, UK and the eurozone, output has fallen far below what virtually everybody expected eight years ago. The same is true of Japan, though the trend in question ended two and a half decades ago. Yet, contrary to what we might also have expected, we do not observe accelerating deflation…. When we look at the high-income economies in this way, we must recognise that they are in a truly extraordinary state. The best way to describe it is as a managed depression: aggressive monetary policies have been sufficient to halt accelerating deflation, but they have been insufficient to produce a strong expansion. This is particularly true of the eurozone…. Recent suggestions by the ECB’s president, Mario Draghi, that the eurozone needs a radical shift in policy regime, is the self-evident truth. Yet the powers that be in the eurozone–notably, the German government–plan to do nothing about it…. We can, at last, see some reasons for optimism about the US and UK… though confidence… cannot be strong. More radical alternatives, such as higher inflation targets and debt restructuring, may yet be needed. In the eurozone and Japan, however, the picture looks more uncertain…”

3. Super-Typhoon Vongfang:

4. Heather Boushey, Nancy Birdsall, Jose Antonio Ocampo, Alonso Segura, Laura Tyson, and Justin Wolfers: Challenges of Job-Rich and Inclusive Growth: Sharing the fruits of growth: “Rising income inequality across economies is a significant concern, not least because countries with higher inequality tend to have growth that is lower and also less durable. This panel discusses how to promote growth that is more equally shared…”

5. Dean Baker: Great Mystery at the Washington Post, Why are People Without Jobs Unhappy About the Economy?: “Steven Mufson uses a wonkblog piece to speculate on why it is that even though we have been in a recovery for more than five years people are still not happy about the economy. He tells us that President Obama has the same problem as President Bush (I), who got trashed on the economy even though revised data show it had been growing rapidly at the start of 1992. While Mufson seeks out expert analysis to try to resolve this paradox, he might try looking at the data for a moment. No one sees the economy. They don’t what the rate of growth is unless they read about it in the newspaper. What they do know is whether they have a job, whether their job is secure, and their pay is rising. If you ask about these questions the only mystery is why Mufson is wasting our time. In 1992 the employment to population ratio was still 1.5 percentage points below its pre-recession level. That would translate into roughly 3.2 million fewer people having jobs in today’s labor market. The current employment to population ratio is down by close to 4.0 percentage points from pre-recession levels, translating into more than 9.0 million fewer people with jobs. (Some of this is due to retirement of baby boomers.) Wages for most workers have been stagnant or declining in the last five years as was the case in 1992. So the real question here is why any serious people would have any question about why the public is sour on the economy. People care about their living standards and security.”

Should Be Aware of:

• Marcus Tullius Cicero Marci filius Marci nepos Cornelia tribu: In Catilinam Prima
• Ryan Cooper: What we can learn from Abraham Lincoln’s greatest mistake
• Gavyn Davies: It’s Draghi versus Weidmann on ECB QE

If Jeff Bezo would simply plug all of his Washington Post reporters into the St. Louis Fed’s FRED, we would have a much better world:

But we have the world we have, and Dean Baker tries to make it better:

Dean Baker: Great Mystery at the Washington Post, Why are People Without Jobs Unhappy About the Economy?: “Steven Mufson uses a wonkblog piece…

…to speculate on why it is that even though we have been in a recovery for more than five years people are still not happy about the economy. He tells us that President Obama has the same problem as President Bush (I), who got trashed on the economy even though revised data show it had been growing rapidly at the start of 1992. While Mufson seeks out expert analysis to try to resolve this paradox, he might try looking at the data for a moment. No one sees the economy. They don’t what the rate of growth is unless they read about it in the newspaper. What they do know is whether they have a job, whether their job is secure, and their pay is rising. If you ask about these questions the only mystery is why Mufson is wasting our time. In 1992 the employment to population ratio was still 1.5 percentage points below its pre-recession level. That would translate into roughly 3.2 million fewer people having jobs in today’s labor market. The current employment to population ratio is down by close to 4.0 percentage points from pre-recession levels, translating into more than 9.0 million fewer people with jobs. (Some of this is due to retirement of baby boomers.) Wages for most workers have been stagnant or declining in the last five years as was the case in 1992. So the real question here is why any serious people would have any question about why the public is sour on the economy. People care about their living standards and security.

Gavyn Davies: Germany Is Stalling: “Extremely weak German industrial production figures…

…for August have come an awkward time for the German government…. The official German line heading into these meetings is that the recovery is proceeding well, both in Germany and in the euro area as a whole, implying that the recent marked weakening in both GDP and inflation data is just a temporary aberration. There is no sign that the Merkel administration is ready to change its longstanding formula for economic success in the euro area: member states should stick to the fiscal targets in the Stability and Growth Pact, and should accelerate structural reforms, so that the expansionary monetary stance provided by the ECB can bear fruit…. This could change, however, if the German economy itself continues to weaken significantly. But how likely is this to happen?… The Fulcrum ‘nowcast’ models… activity growth rate has slowed from about 2.6 per cent in late 2013 to 0.9 per cent now…. It has not fallen yet into negative territory on an underlying basis, but it is certainly not acting as a powerful locomotive for the European economy. Far from it…. The Q2 official GDP growth rate of -0.6 per cent was already worse than had been expected…. The central estimate of the latest ‘nowcast’ for Q3 is that the GDP growth rate will rebound to 1.4 per cent annualised… about a 28 per cent probability [of a second negative number].”