Tag: Monetary Policy

Must-Read: Martin Wolf: Lunch with the FT: Ben Bernanke

Posted on by Brad DeLong

Must-Read: Martin Wolf: Lunch with the FT: Ben Bernanke: “‘The notion that the Fed has somehow enriched the rich…

…through increasing asset prices doesn’t really hold up…. The Fed basically has returned asset prices… to trend… [and] stock prices are high… because returns are low…. The same people who criticise the Fed for helping the rich also criticise the Fed for hurting savers…. Those two… are inconsistent….

‘Should the Fed not try to support a recovery?… If people are unhappy with the effects of low interest rates, they should pressure Congress… and so have a less unbalanced monetary-fiscal policy mix. This is the fourth or fifth argument against quantitative easing after all the other ones have been proven to be wrong….’ Other critics argue, I note, that the Fed’s intervention prevented the cathartic effects of a proper depression. He… respond[s]… that I have a remarkable ability to keep a straight face while recounting… crazy opinions…. ‘We were quite confident from the beginning there would be no inflation problem…. As for… the Andrew Mellon [US Treasury secretary] argument from the 1930s… certainly among mainstream economists, it has no credibility. A Great Depression is not going to promote innovation, growth and prosperity.’ I cannot disagree, since I also consider such arguments mad….

Does… blame… lie in pre-crisis monetary policy… interest rates… too low… in the early 2000s?… ‘Serious studies that look at it don’t find that to be the case…. Shiller… has a lot of credibility…. The Fed had some complicity… in not constraining the bad mortgage lending… [and] the structural vulnerabilities in the funding markets….’ Thus, lax regulation…. Has the problem been fixed?… ‘It’s an ongoing project…. You can’t hope to identify all the vulnerabilities in advance. And so anything you can do to make the system more resilient is going to be helpful.’… I push a little harder on the costs of financial liberalisation. He agrees that, in light of the economic performance in the 1950s and 1960s, ‘I don’t think you could rule out the possibility that a more repressed financial system would give you a better trade-off of safety and dynamism.’ What about the idea that if the central banks are going to expand their balance sheets so much, it would be more effective just to hand the money directly over to the people rather than operate via asset markets?… A combination of tax cuts and quantitative easing is very close to being the same thing.’ This is theoretically correct, provided the QE is deemed permanent…

Must-Read: Charles Bean: Causes and Consequences of Persistently Low Interest Rates

Posted on by Brad DeLong

Must-Read: So: On the one hand, risk tolerance is disappointingly and inappropriately low–but should return to normal some day. On the other hand, investors are “reaching for yield” and taking inappropriate risks by crowding into bubbly assets. I cannot be the only person who wants a real model of how this is supposed to work, and real evidence that it is a factor at work, plus a real argument that higher interest rates would exert enough of a curb to pass some reasonable benefit-cost test. The very sharp Gabriel Chodorow-Reich looked for this and did not find it…

Charles Bean: Causes and Consequences of Persistently Low Interest Rates: “Demographic developments… the partial integration of China…

…and the associated capital outflows…. a lower propensity to invest… as a result of heightened risk aversion…. Rates should eventually return to more normal levels…. But… the time scale… is highly uncertain and will be influenced by longer-term fiscal and structural policy choices…. A world of persistently low interest rates may be more prone to generating a leveraged ‘reach for yield’ by investors and speculative asset-price boom-busts. While prudential policies should be the first line of defence against such financial stability risks, their efficacy is by no means assured. In that case, monetary policy may need to come into play as a last line of defence…

Central Banks Are Not Agricultural Marketing Boards: Depression Economics, Inflation Economics and the Unsustainability of Friedmanism

Posted on by Brad DeLong

Central Banks Are Not Agricultural Marketing Boards: Depression Economics, Inflation Economics and the Unsustainability of Friedmanism

Insofar as there is any thought behind the claims of John Taylor and others that the Federal Reserve is engaged in “price controls” via its monetary policy actions.

Strike that.

There is no thought at all behind such claims at all.

Insofar as one did want to think, and so construct an argument that the Federal Reserve’s monetary policy operations are destructive and in some ways analogous to “price controls”, the argument would go something like this:

The Federal Reserve’s Open Market Committee’s operations are like those of an agriculture marketing board–a government agency that sets the price for, say, some agricultural product like butter or milk. Some of what is offered for sale at that price that is not taken up by the private market, and the rest is bought by the government to keep the price at its target. And the next month the government finds it must buy more. And more. And more.

Such policies produce excess supplies that then must be stored or destroyed: they produce butter mountains, and milk lakes.

The resources used to produce the butter mountains and milk lakes is wasted–it could be deployed elsewhere more productively. The taxes that must be raised to pay for the purchase of the butter and milk that makes up the mountains and the lakes discourages enterprise and employment elsewhere in the economy, and makes us poorer. Taxes are raised (at the cost of an excess burden on taxpayers) and then spent to take the products of the skill and energy of workers and… throw them away. Much better, the standard argument goes, to eliminate the marketing board, let the price find its free-market equilibrium value, provide incentives for people to move out of the production of dairy products into sectors where private demand for their work exists, and keep taxes low.

Now you can see that a central bank is exactly like an agricultural marketing board, except for the following little minor details:

  1. An agricultural marketing board must impose taxes to raise the money finance its purchases of butter and milk. A central bank simply prints–at zero cost–the money to finance its purchase of bonds.
  2. The butter mountains and milk lakes that the agricultural marketing board owns cannot be sold without pushing the price down below its free-market equilibrium and thus negating the purpose of the board. A central bank does not want to sell its bond mountains, but merely to collect interest and hold them to maturity, at which point they are simply money mountains.
  3. The butter mountains and milk lakes are useless for the agricultural marketing board: all it can do with them is simply watch them rot away. The bond mountain turns into a money mountain–seigniorage–which the central bank then gives to the government, which lowers taxes as a result.

So a central bank is exactly like an agricultural marketing board–NOT!!! They are identical–except that they are completely different.

But, somewhat smarter John Taylor and others might say, a central bank is like an agricultural marketing board. The extra money it puts into circulation when its bonds mature and it transfers profits to the government devalue and debauch the currency. It raises the real resources needed to finance its bond purchases by levying an “inflation tax” on money holders–by reducing the value of their cash just as an income tax reduces the (after-tax) value of incomes.

And I would agree, if the inflation comes. Under conditions of what I like to call Inflation Economics, money-printing and bond purchases do push the interest rate below the natural rate of interest–push bond prices above their natural price–as defined by Knut Wicksell. Money-printing and bond purchases then do indeed cause economic problems somewhat analogous to those of a marketing board that keeps the prices of butter and milk above their natural price.

But what if the inflation does not come? What if our economy’s phase is one of not Inflation Economics but Depression Economics, in which the central bank is not pushing the interest rate below its Wicksellian natural rate but is instead stuck trying to manage a situation in which the Wicksellian natural rate of interest is less than zero?

Then the analogies break down completely. Money-printing is then not an inflationary tax but instead a utility-increasing provision of utility services. Bond purchases do not create an overhang that cannot be sold without creating an opposite distortion from the optimal price but instead push the temporal slope of the price system toward what a benevolent central planner would want the temporal slope of the price level to be.

Milton Friedman was very clear that economies could either have too much money (Inflation Economics) or too little money (Depression Economics)–and that a central bank was needed to try to hit the sweet spot. He hoped that hitting the sweet spot could be made into a somewhat automatic rule-controlled process, but he was wrong.

So trying to construct a thinking argument that central banks are engaged in something analogous to “price controls” via their monetary policy actions leads even a substantially sub-Turing entity to the conclusion: Sometimes, under conditions of “Inflation Economics”, but not now.

And let me offer all kudos to those like David Beckworth, Scott Sumner, and Jim Pethokoukis who are trying to convince their political allies of these points that I regard as basic and Wicksellian–cutting-edge macro from 125 years ago. But I think that Paul Krugman is right when he believes that they are going to fail. Let me turn the mike over to Paul Krugman to explain why he thinks they are going to fail:

Paul Krugman: More Artificial Unintelligence: “David Beckworth pleads with fellow free-marketeers to stop claiming that…

…low interest rates are “artificial” and comparing them to price controls…. The Fed isn’t imposing a price ceiling… monetary policy… nothing at all like price controls…. What interest rates would be in the absence of distortions and rigidities [is] the Wicksellian natural rate…. The actual interest rate, at zero, is above the natural rate…. But… Beckworth should be asking… why almost nobody on the right is willing to think… not just… ignoramuses like Rand Paul and George Will. The “low interest rates = price controls” meme is bang-your-head-on-the-table stupid–but… John Taylor…. [It’s] a line of argument that people on the right really, really like….

Beckworth is… tak[ing] the… Friedman position… trusting markets… except… [for] the business cycle…. This is… [intellectually] problematic…. You need… market failure to give monetary policy large real effects, and… why… is the only important failure?…

Let me, as an aside, point out that it could indeed be the case that monetary policy joins police, courts, and defense as they only significant areas in which the costs of rent-seeking, regulatory-capture, and other government failures are less than the costs of the market failures that the government could successfully neutralize. It’s unlikely. But it’s possible. Indeed, Milton Friedman thought that that was the case. And he was not at all a dumb man. And laying down general rules sector-by-sector about the relative magnitudes of market and government failures is almost surely a mistake. As John Maynard Keynes wrote in his “The End of Laissez-Faire”:

We cannot therefore settle on abstract grounds, but must handle on its merits in detail what Burke termed: “one of the finest problems in legislation, namely, to determine what the State ought to take upon itself to direct by the public wisdom, and what it ought to leave, with as little interference as possible, to individual exertion…”

But let’s give the mike back to Krugman to make his major point:

More important… this position turns out to be politically unsustainable. “Government is always the problem, not the solution, except when it comes to monetary policy” just doesn’t cut it for modern conservatives. Nor did it cut it for traditional conservatives. Remember, during the 1930s people like Hayek were liquidationists, with Hayek specifically denouncing expansionary monetary policy during a slump as “the creation of artificial demand.” The era of Friedmanism, of free-market views paired with tolerance for monetary stimulus, was a temporary and unsustainable interlude, and no amount of sensible argumentation will bring it back.

But this doesn’t mean that Jim, Scott, David, and company should not try, no? It is not just the Milton Friedman was a galaxy-class expert at playing intellectual Three-Card Monte, no? It is true that at times my breath is still taken away at Friedman’s gall in claiming that a “neutral” and “non-interventionist” monetary policy was one which had the Federal Reserve Bank of New York buying and selling bonds every single day in a frantic attempt to make Say’s Law, false in theory, true in practice. But he wiped the floor with the Hayekians intellectually, culturally, academically, and politically for two generations.

Krugman’s line “claiming that laissez-faire is best for everything save monetary policy (and property rights, and courts, and police, and defense) is intellectually unstable and unsustainable in the long-run” may well be true. But as somebody-or-other once said:

This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again…

UPDATE: And I should add a link to Krugman’s original:

Paul Krugman: Artificial Unintelligence: “In the early stages of the Lesser Depression…

…those of us who knew a bit about the… 1930s… felt… despair…. People who imagined themselves sophisticated and possessed of deep understanding were resurrecting 75-year-old fallacies and presenting them as deep insights…. [Today] I feel an even deeper sense of despair–because people are still rolling out those same fallacies, even though in the interim those of us who remembered and understood Keynes/Hicks have been right about most things, and those lecturing us have been wrong about everything. So here’s William Cohan in the Times, declaring that the Fed should ‘show some spine’ and raise rates even though there is no sign of accelerating inflation. His reasoning….

The price of borrowing money–interest rates–should be determined by supply and demand, not by manipulation by a market behemoth….

[However,] the Fed sets interest rates, whether it wants to or not–even a supposed hands-off policy has to involve choosing the level of the monetary base somehow…. How would you know if the Fed is setting rates too low? Here’s where Hicks meets Wicksell: rates are too low if the economy is overheating and inflation is accelerating. Not exactly what we’ve seen in the era of zero rates and QE…. There are arguments that the Fed should be willing to abandon its inflation target so as to discourage bubbles. I think those arguments are wrong-but… they have nothing to do with the notion that current rates are somehow artificial, that we should let rates be determined by ‘supply and demand’. The worrying thing is that… crude misunderstandings… are widespread even among people who imagine themselves well-informed and sophisticated. Eighty years of hard economic thinking, and seven years of overwhelming confirmation of that hard thinking, have made no dent in their worldview. Awesome.

Must-Read: Matt Phillips: Bernanke: I’m not really a Republican anymore

Posted on by Brad DeLong

Must-Read: As I have said before and will stay again, the Republican Party could be taking a serious policy victory lap right now, not just with respect to health policy–as Mitt Romney tried to do yesterday before losing his nerve and pulling back–and with respect to monetary policy. they could be pointing out right now that the most successful recovery in the North Atlantic from 2008-9 was engineered by Republican Ben Bernanke following Friedmanite countercyclical monetary policies.

But no!

They would rather be Hayekians, predicting imminent hyperinflation…

Why? I think it’s the Fox News-ification of political discourse: terrify people in the hope that you will then gain their attention and they will give you money…

Matt Phillips: Bernanke: I’m not really a Republican anymore: “Ben Bernanke has publicly broken ranks with the Republican party…

…In one of the more revealing passages of… The Courage to Act… [he] lays out his experience with Republican lawmakers during the twin financial and economic crises….Continual run-ins with hard-right Republicans… pushed him away from the party that first put him in charge of the Fed….

[T]he increasing hostility of the Republicans to the Fed and to me personally troubled me, particularly since I had been appointed by a Republican president who had supported our actions during the crisis. I tried to listen carefully and accept thoughtful criticisms. But it seemed to me that the crisis had helped to radicalize large parts of the Republican Party….

The former Princeton economics professor said he had:

lost patience with Republicans’ susceptibility to the know-nothing-ism of the far right. I didn’t leave the Republican Party. I felt that the party left me.

He later concludes: ‘I view myself now as a moderate independent, and I think that’s where I’ll stay’…

Must-Read: Martin Wolf: Lunch with Ben Bernanke

Posted on by Brad DeLong

Martin Wolf: Lunch with the FT: Ben Bernanke: “Critics complain that the Fed… let ordinary people drown…

…How does he respond? ‘Rising inequality… is a long-term trend that goes back at least to the 1970s. And the notion that the Fed has somehow enriched the rich through increasing asset prices doesn’t really hold up… [because] the Fed basically has returned asset prices… to trend… [and] stock prices are high… because returns are low…. The same people who criticise the Fed for helping the rich also criticise the Fed for hurting savers…. Those two… are inconsistent. But what’s the alternative? Should the Fed not try to support a recovery?… If people are unhappy with the effects of low interest rates, they should pressure Congress to do more on the fiscal side, and so have a less unbalanced monetary-fiscal policy mix. This is the fourth or fifth argument against quantitative easing after all the other ones have been proven to be wrong. And this is certainly not an argument for the Fed to do nothing and let unemployment stay at 10 per cent.’

Other critics argue, I note, that the Fed’s intervention prevented the cathartic effects of a proper depression. He… respond[s]… that I have a remarkable ability to keep a straight face while recounting… crazy opinions. I add that many critics still expect hyperinflation any day now. ‘Well, we were quite confident from the beginning there would be no inflation problem. And, of course, the greater problem has been getting inflation up to target. As for allowing the economy to go into collapse, this is the Andrew Mellon [US Treasury secretary] argument from the 1930s. And I would think that, certainly among mainstream economists, it has no credibility. A Great Depression is not going to promote innovation, growth and prosperity.’ I cannot disagree, since I also consider such arguments mad….

Neither he nor the Fed expected the meltdown. Does the blame for these mistakes lie in pre-crisis monetary policy?… Had interest rates not been kept too low for too long in the early 2000s?… ‘[Was] monetary policy… in fact, a major contributor to the housing bubble[?]…. Serious studies that look at it don’t find that to be the case…. Shiller… who has a lot of credibility… says that: it wasn’t monetary policy at all…. The Fed had some complicity… in not constraining the bad mortgage lending and excessive risk-taking that was permeating the system. This, together with the structural vulnerabilities in the funding markets….’ Thus, lax regulation was to blame. Has the problem been fixed? ‘I think it’s an ongoing project,’ he replies. ‘You can’t hope to identify all the vulnerabilities in advance. And so anything you can do to make the system more resilient is going to be helpful.’…

Some argue that the financial sector is riddled with perverse incentives: limited liability; excessive leverage; ‘too-big-to-fail’ banks; and a range of explicit and implicit guarantees. How far does he agree? ‘I think that there was, for rational or irrational reasons, an upsurge in risk-taking. And if you’re taking risks, then I have to take the same risks, or else I get left behind. There’s two ways to get rid of ‘too-big-to-fail’. One is by having a lot of capital. And the other approach is via the liquidation authority in… Dodd-Frank….’ But, he adds, ‘if you break the firms down to the size of community banks, you lose a lot of functionality. At the same time, you don’t necessarily stop financial panics, because we had financial panics in the 1930s.’… I push a little harder on the costs of financial liberalisation. He agrees that, in light of the economic performance in the 1950s and 1960s, ‘I don’t think you could rule out the possibility that a more repressed financial system would give you a better trade-off of safety and dynamism.’

What about the idea that if the central banks are going to expand their balance sheets so much, it would be more effective just to hand the money directly over to the people rather than operate via asset markets?… A combination of tax cuts and quantitative easing is very close to being the same thing.’ This is theoretically correct, provided the QE is deemed permanent…

Must-Read: Adair Turner: Debt Déjà Vu

Posted on by Brad DeLong

Must-Read: Not that we know what the right model is, mind you. But Adair Turner believes that it is more likely than not that the model the Federal Reserve is currently using to make its forecasts off of–the model that sees steady non-recessionary U.S. economic growth even with imminent interest-rate lift-off–is the wrong model:

Adair Turner: Debt Déjà Vu: “Financial markets have repeated the same error–predicting that US interest rates will rise within about six months…

…This serial misjudgment is the result… of a failure to grasp the strength and global nature of… deflationary forces…. We are caught in a trap where debt burdens do not fall, but simply shift among sectors and countries, and where monetary policies alone are inadequate to stimulate global demand…. The origin of this malaise lies in the creation of excessive debt to fund real-estate investment and construction… during Japan’s 1980s boom… since the financial crisis of 2008… [a] pattern has been repeated elsewhere… in the United States and several European countries…. Advanced economies’ cumulative private debt-to-GDP ratio has fallen slightly–from 167% to 163%… but public debt has grown from 79% to 105% of GDP. Fiscal austerity has therefore seemed essential; but it has exacerbated the deflationary impact of private deleveraging.

Before 2008, China’s economy was highly dependent on credit expansion, but not within the country itself. Rather, it ran large current-account surpluses…. [Starting] in late 2008… China’s government unleashed a massive credit-fueled construction boom… total credit growing from around 140% of GDP to more than 220%. That boom has now ended, leaving apartment blocks in second- and third-tier cities that will never be occupied, and loans to local governments and state-owned enterprises that will never be repaid….

QE alone cannot stimulate enough demand in a world where other major economies are facing the same challenges. By boosting asset prices, QE is meant to spur investment and consumption. But its effectiveness in stimulating domestic demand remains uncertain…. Central bank governors like the ECB’s Mario Draghi and the BOJ’s Haruhiko Kuroda often emphasize QE’s ability to deliver competitive exchange rates. But that approach simply shifts demand from one economy to another…. Seven years after 2008, global leverage is higher than ever, and aggregate global demand is still insufficient to drive robust growth. More radical policies–such as major debt write-downs or increased fiscal deficits financed by permanent monetization–will be required to increase global demand, rather than simply shift it around.

Must-Read: Tim Duy: Fed Struggles with the High Water Mark

Posted on by Brad DeLong

Must-Read: I continue to fail to understand the apparent thinking of the center of the Federal Reserve. The following argument seems to me to be obviously correct:

  1. Asymmetric risks and the strong desirability of not returning to the zero lower bound after interest-rate lift-off call for raising interest rates not early and slow but late and fast.
  2. That plus the strong desirability of making it clear by actions that show their consequences in the data 2%/year for the PCE chain index–2.4%/year for the core-CPI–is a target and not a ceiling means that optimal risk management is to wait until rising inflation is present in the data before beginning lift-off
  3. The risks of damaging credibility via error are much less if the policy is to delay lift-off until there are signs of rising inflation as opposed to lifting-off as soon as demand plus the shakily-estimated Phillips curve say rising inflation is coming.
  4. Committee harmony is lost, whether there are formal dissents in December or not.

Even if the center of the Federal Reserve has not internalized Staiger, Stock, and Watson and pretends that their estimated Phillips curve is is the eternal truth of The One Who Is–on the grounds that “you need a forecast to make policy”–interest rate increases in December make no sense, and interest rate increases in March make no sense unless core inflation starts trending up right now:

FRED Graph FRED St Louis Fed

Tim Duy: Fed Struggles with the High Water Mark: “If we get two more reports hovering around 200k a month [in employment growth]…

…between now and December, matched with generally consistent data across other indicators, then December is on the table…. If jobs growth slows to 100k a month… we are looking at deep into 2016 before any hike. Around 150k is the gray area…. I suspect that more numbers like the last two will make the December meeting much like September’s. That I fear is my current baseline–another close call in which the Fed concludes to take a pass.

Gavin Davies: Is the US slowdown for real?: “Several investment banks’ economics teams have ruled out a December rise…

…The expected federal funds rate at the end of 2016 implies only two Fed rate hikes in total over that entire period. Clearly, investors increasingly believe that the US economy is now slowing enough to throw the Fed off course. This big change in market opinion is, frankly, surprising. The rise of 142,000 in non-farm payrolls in September was not all that weak…. The US slowdown [is] for real… but it is not yet very severe…. Unless it grows worse in the next few weeks, it is unlikely to dislodge the Fed from the path it has now firmly chosen.

Must-Read: Paul Krugman: Rethinking Japan

Posted on by Brad DeLong

Must-Read: Paul Krugman is musing about and rethinking his 1998 analysis of Japan and its macroeconomic problems:

NewImage

Paul Krugman: Rethinking Japan: “[How] would change what I said in my 1998 paper…

…on the liquidity trap[?]… Japan and the world look different…. First, the immediate economic problem is… weaning the economy off fiscal support. Second… demand weakness looks… permanent…. Back in 1998 Japan… [was] operating far below potential…. This is, however, no longer the case…. Output per working-age adult has grown faster than in the United States since around 2000…. [But] Japan’s relatively healthy output and employment levels depend on continuing fiscal support… ever-rising debt/GDP…. So far this hasn’t caused any problems…. But even those of us who believe that the risks of deficits have been wildly exaggerated would like to see the debt ratio stabilized and brought down at some point…..

With policy rates stuck at zero, Japan has no ability to offset the effects of fiscal retrenchment with monetary expansion. The big reason to raise inflation… is to… allow… monetary policy to take over from fiscal policy…. But what would it take to raise inflation?… Back in 1998… [I assumed] the Wicksellian natural rate of interest… would return to a normal, positive level at some future date… [thus] the liquidity trap became an expectations problem…. But what is this future… normality[?]… [If] a negative Wicksellian rate is… permanent… [even] a credible promise to be irresponsible might do nothing: if nobody believes that inflation will rise, it won’t….

The only way to be at all sure… is… a changed monetary regime with a burst of fiscal stimulus…. While the goal… is… to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion… really aggressive policy, using fiscal and monetary policy to boost inflation… setting the target high enough… escape velocity. And while Abenomics has been a favorable surprise, it’s far from clear that it’s aggressive enough to get there.

In many ways, things are even worse than Paul says. Paul Krugman’s original argument assuming that the economy would eventually head towards a long-run equilibrium in which flexible wages and prices what make Say’s Law hold true, in which there would be a positive natural nominal rate of interest, and thus in which the price level would be proportional to the money stock. That now looks up for grabs. It is the fact that that is up for grabs that currently disturbs Paul. Without a full-employment Say’s Law equilibrium out there in the transversality condition to which the present day is anchored by intertemporal financial-market and intertemporal consumer-utility arbitrage, all the neat little mathematical tricks that Paul and Olivier Blanchard built up at the end of the 1970s to solve for *the* current equilibrium break in their hands. And we enter Roger Farmer-world–a scary and frightening place.

But there is even more. Paul Krugman’s original argument also assumed back-propagation into the present via financial-market intertemporal arbitrage and consumer-satisfaction intertemporal utility arbitrage of the effects of that future well-behaved full-employment equilibrium. The equilibrium has to be there. And the intertemporal arbitrage mechanisms have to work. Both have to do their thing.

But, as Paul wrote in another context:

Paul Krugman**: Multipliers and Reality: “Rigorous intertemporal thinking…

…even if empirically ungrounded, can be useful to focus one’s thoughts. But as a way to think about the reality of spending decisions, no…. Consider… what the public knows about the biggest new government program of recent years[, ObamaCare]…. If people are that uninformed about something that big, imagining that they do anything like the calculations assumed in DSGE models is ludicrous. Surely they rely on rules of thumb that don’t make use of the kind of information that plays such a large role in our models…

Suppose the full employment equilibrium is really out there. People still have to anticipate that it is out there, and then take account of the fact that it is out there and the way that a rational-expectations utility-maximizing agent would.

Now sometimes we get lucky.

Sometimes the fact that one can transact on financial markets on a large scale means that even if only a few are willing to bet on fundamentals, the fact that they can make huge fortunes betting on fundamentals on a large scale drives current asset prices to fundamental values, and those asset prices then drive the current behavior even those who do not know anything about the future equilibrium that is driving the present via this process of expectational back-propagation inductive-unraveling.

But when we are talking about inducing people to spend more now because they fear their money will be worth less then in the future when the debt will have been monetized–well, if that were an important and active channel, we would not now have our current sub-2%/year inflation in Japan and the United States, would we?

Time to drop a link to my New Economic Thinking, Hicks-Hansen-Wicksell Macro, and Blocking the Back Propagation Induction-Unraveling from the Long Run Omega Point: The Honest Broker for the Week of May 31, 2015.

In fact, let me just repeat the whole thing below the fold…

Over at Equitable Growth: In the long run… when the storm is long past, the ocean is flat again.

At that time–or, rather, in that logical state to which the economy will converge if values of future shocks are set to zero–expected inflation will be constant at about the 2% per year that the Federal Reserve has announced as its target. At that time the short-term safe nominal rate of interest will be equal to that 2% per year of expected inflation, plus the real profits on marginal investments, minus a rate-of-return discount because short-term government bonds are safe and liquid. At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. Why? Because of the powerful incentive to economize on cash holdings provided by the the sacrifice of several percent per year incurred by keeping cash in your wallet rather than in bonds. And at that time the price level will be proportional to the monetary base. READ MOAR

That was and is the logic behind so many economists’ beliefs. Their beliefs before 2008 that economies could not get stuck in liquidity traps (because central banks could always create inflation by boosting the monetary base); beliefs in 2008 and 2009 that economies’ stays in liquidity traps would be very short (because central banks were then boosting the monetary base); and beliefs since then that (because central banks had boosted the monetary base) those who believe will not taste death before, but will live to see exit from the liquidity trap and an outburst of inflation as the Federal Reserve tries and fails at the impossible task of shrinking its balance sheet to normal without inflation–all of these beliefs hinged and hinge on a firm and faithful expectation that this long run is at hand, or is near, or will soon draw near (translations from the original koine texts differ). Because the long run will come, increases now in the monetary base of sufficient magnitude that are believed to be permanent will–maybe not now, but soon, and for the rest of our lives, in this long run–produce equal proportional increases in the price level, and thus substantial jumps in the inflation rate as the price level transits from its current to its long-run level.

Moreover, there is more to the argument: The long run is not here. The long run may not be coming soon. But the long run will come. And so there will will a time when the long run is near. At that time, those who are short long-term bonds will be about to make fortunes as interest rates normalize and long bond prices revert to normal valuation ratios. At that time, those who are leveraged and short nominal debt will be about to make fortunes as the real value of their debt is heavily eroded by the forthcoming jump in the price level .

And there is still another step in the argument: When the long run is near but not yet here–call it the late medium run–investors and speculators will smell the coffee. This late medium run will see investors and speculators frantically dumping their long bonds so as not to be caught out as interest rates spike and bond prices collapse. It will see investors and speculators frantically borrowing in nominal terms to buy real assets and currently-produced goods and services so as not to be caught out when the price level jumps. Thus even before the long run is here–even in the late medium run–their will already be very powerful supply-and-demand forces at work. Those forces will be pushing interest-rates up, pushing real spending levels, and pushing price levels and inflation rates up.

The next step in the argument continues the induction unraveling: When it is not yet the late medium run but only the medium run proper, rational investors and speculators must still factor the future coming of the long run into their decisions. The long run may not be near. But it may be that soon markets will conclude the long run is near. Thus in the medium run none will want their portfolios to be so imbalanced that when the late medium run does come and with it the time to end your exposure to long-term bonds and to nominal assets and leverage up, you are on the wrong foot and so last person trying to get through the door in the stampede. There may be some short run logic that keeps real spending low, prices low, inflation quiescent, and interest rates at zero. But that logic’s effects will be severely attenuated when the medium run comes, for then investors and speculators will be planning not yet for the long run or even the at-handness of the long run, but for the approach of the approach of the long run.

And so we get to the final step of the induction-unraveling: Whatever may be going on in the short run must thus be transitory in duration, moderate in their effects, and limited in the distance it can can push the economy away from its proper long run equilibrium. And it certainly cannot keep it there. Not for long.

This is the real critique of Paul Krugman’s “depression economics”. Paul can draw his Hicksian IS-LM diagrams of an economy stuck in a liquidity trap:

The Inflationista Puzzle NYTimes com

He can draw his Wicksellian I=S diagrams of how the zero lower bound forces the market interest rate above the natural interest rate at which planned investment balances savings that would be expected were the economy at full employment:

Lifestream vpdoc 2015 06 02 Tu Krugman Feldstein

Paul can show, graphically, that conventional monetary policy is then completely ineffective–swapping two assets that are perfect substitutes for each other. Paul can show, graphically, that expansionary fiscal policy is then immensely powerful and has no downside: it does not generate higher interest rates; it does not crowd out productive private investment; and, because interest rates are zero, it entails no financing burden and thus no required increase in future tax wedges. But all this is constrained and limited by the inescapable and powerful logic of the induction-unraveling propagating itself back through the game tree from the Omega Point that is the long run equilibrium. In the IS-LM diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the IS curve up and to the right, and thus leading the economy to quickly exist the liquidity trap. In the Wicksellian I=S diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the I=S curve up so that the zero lower bound will soon no longer constrain the economy away from its full-employment equilibrium.

The “depression economics” equilibrium Paul plots on his graph is a matter for today–a month or two, or a quarter or two, or at most a year or two.

But it will soon be seven years since the U.S. Treasury Bill rate was more than whispering distance away from zero. And it is now more than two decades since Japan’s short-term bonds sold at less than par.

Paul has a critique of the extremely sharp Marty Feldstein’s latest over at Project Syndicate (parenthetically, I must say it is rather cruel for Project Syndicate to highlight Feldstein’s August 2012 “Is Inflation Returning” in site-searches for “Feldstein”):

Paul Krugman: The Inflationista Puzzle: “Martin Feldstein has a new column on what he calls the ‘inflation puzzle’…

…the failure of inflation to soar despite the Fed’s large asset purchases, which led to a very large rise in the monetary base. As Tony Yates points out, however, there’s nothing puzzling at all about what happened; it’s exactly what you should expect when interest rates are near zero…. This isn’t an ex-post rationale, it’s what many of us were saying from the beginning. Traditional IS-LM analysis said [it]… so did the translation of that analysis into a stripped-down New Keynesian framework that I did back in 1998, starting the modern liquidity-trap literature. We even had solid recent empirical evidence: Japan’s attempt at quantitative easing in the naughties, which looked like this:

NewImage

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen.

Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right…. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves[?] ([But] Japan never paid such interest[.]).

Anyway, inflation is just around the corner, the same way it has been all these years.

Unlike Paul, I get why moderate conservatives like Feldstein didn’t find “all this convincing” back in 2009. I get it because I only reluctantly and hesitantly found it convincing. Feldstein got the Hicksian IS-LM and the Wicksellian S=I diagrams: he just did not believe that they were anything but the shortest of short run equilibria. He could feel in his bones and smell in the air the up-and-to-the-right movement of the IS curve and the upward movement of the S=I curve as investors, speculators, and businesses took look at the size of the monetary base and incorporated into their thinking about the near future the backward induction-unraveling from the long run Omega Point. My difference with Marty in 2009 is that he thought then that the liquidity trap was a 3 month-1 year phenomenon–that that was the duration of the short run–while I was much more pessimistic about the equilibrium-restoring forces of the market: I thought it was a 3 year-5 year phenomenon.

And it was not just me. Consider Ben Bernanke. I have no memory any more of who was writing [Free Exchange] back in 2009. But whoever it was was very sharp, and wrote:

????: Person of the next five to ten years: “There are those who blame [Bernanke] for missing all the warning signs…

…those who blame him for managing the crisis in the most Wall Street-friendly way… those who blame him for laying the groundwork for a future asset bubble or inflation crisis…. I think his defining decision… has been to conclude that 10% unemployment is acceptable–that having averted a Depression-style 25% unemployment scenario, his countercyclical work is complete… that the risk of sustained high unemployment is outweighed by the risk of… efforts to boost the economy… by asking for more fiscal stimulus… targeting nominal GDP or… committing… to some [higher] level of inflation….

Bernanke believes most of the increase in unemployment… to be cyclical… does not think that pushing… unemployment… down to… 7% would overextend the economy…. He simply seems to think that leaving his primary job half done is acceptable. That’s a pretty momentous choice, affecting millions of people directly and billions indirectly. It will shape American politics and economics for the next decade, at least…. He deserves… person of the year…. But reappointment? That’s another story entirely.

What this leaves out is that Bernanke was willing to take his foot off the gas in late 2009 with an unemployment rate of 10% because, like Marty, he could smell the back-propagation of the induction-unraveling of the short run equilibrium. He us expected that, with his foot off the gas, unemployment would be 8.5% by the end of 2010, 7% by the end of 2011, 6% by the end of 2013–and thus that further expansionary policies in 2010-2011 would run some risk of overheating the economy in 2013-2014 that was not worth the potential game. He didn’t see the liquidity trap short run as as brief as Marty did. But he also didn’t see the short run as as long as I did–and I have greatly underestimated its duration.

(Someday I want Christina Romer to write up her memoir of late 2009-late 2010, as she wandered the halls of the White House, the Federal Reserve, the IMF, and the OECD, trying to convince a bunch of economists certain that the short run was a year or two that all the historical evidence we had–the Great Depression and Japan’s Lost Decades, plus what we dimly think we know about 1873-9, and so forth–suggested, rather, that it the short run would, this time, be a five to ten-year phenomenon. Yet even with backing by Rinehart and Rogoff on the short run equilibrium duration (albeit not the proper fiscal policy) front, she made little impression and had next to no influence.)

Ahem. I have gotten off track…

My point:

Back in late 2009 I thought that the liquidity-trap short run was likely to be a three-to-five-year phenomenon. It has now been six. And the Federal Reserve’s proposed interest-rate liftoff now scheduled for the end of 2015 appears to me profoundly unwise as a matter of technocratic optimal control, prudent policy, and recognition of the situation. The duration of the short run thus looks to me to be, this time, not three to five years but more like ten. Or more. The backward-propagation of the induction-unraveling of the short run under pressure of the healing rays of the long run Omega Point is not just not as strong as Marty Feldstein thought, is not just not as strong as I thought, it is nearly non-existent.

Thus I find myself getting somewhat annoyed at Paul Krugman when he writes that:

Paul Krugman: Choose Your Heterodoxy: “A lot of what I use is 1930s economic theory…

…via Hicks. And I should be deeply ashamed…. [But] plenty of physicists who still use Newtonian dynamics, which means that they’re seeing the world through the lens of 17th-century theory. Fools!… Farmer is trying to explain an empirical regularity he thinks he sees, but nobody else does–a complete absence of any tendency of the unemployment rate to come down when it’s historically high. I’m with John Cochrane here: you must be kidding…

Or that:

Paul Krugman: Nonlinearity, Multiple Equilibria, and the Problem of Too Much Fun: “Was the crisis something that requires novel multiple-equilibrium models to understand?…

…That’s far from obvious. The run-up to crisis looks to me more like Shiller-type irrational exuberance. The events of 2008 do have a multiple-equilibrium feel to them, but not in a novel way… pull Diamond-Dybvig…. And since the crisis struck, as I’ve argued many times, simple Hicksian macro–little equilibrium models with some real-world adjustments–has been stunningly successful…

Or:

Paul Krugman: Learned Helplessness: “We knew all about liquidity traps, and had at least thought about balance-sheet crises…

…a decade ago…. The Return of Depression Economics in 1999. The world we’re now in isn’t that different from the world I suspected, back then, we’d find ourselves in. Oh, and about Roger Farmer and Santa Fe and complexity and all that: I was one of the people who got all excited about the possibility of getting somewhere with very detailed agent-based models–but that was 20 years ago. And after all this time, it’s all still manifestos and promises of great things one of these days…

The problem is that the macroeconomics that Paul Krugman learned at Jim Tobin’s knee wasn’t just 1930s-style Hicks-Hansen Keynesianism. It was the 1970s adaptive-expectations Phillips Curve neoclassical synthesis–nearly the same stuff that I first learned at Marty Feldstein and Olivier Blanchard’s knees in the spring of 1980. That is the framework that Marty is using know, and that generates his puzzlement. That framework had a short run of 1-2 years, a medium-run transition-dynamics phase of 2-5 years, and a long run of 5 years or more baked into it. You cannot–or at least I cannot–just throw away the medium run transition dynamics* and the declaration that the long run Omega Point is five years out, and say that mainstream economics does well. You need to explain why the back-propagation induction-unraveling worked at its proper time scale in the 1970s and the 1980s, but is nowhere to be found now.

And so I am much less confident that I have solid theoretical ground under my feet than Paul Krugman does.

Monday Smackdown Watch: Paul Krugman Admonishes Me on My Making Out of Milton Friedman Not a Golden, But a Paper-Money Calf

Posted on by Brad DeLong
NewImage

Paul Krugman: Milton, Money, and Interest Rates: “I have a moderate disagreement with Brad DeLong…

…[who] has been arguing that demands for tight money are, in fact, contrary to the bankers’ own interests:

It was Milton Friedman who insisted, over and over again, that in any but the shortest of runs high nominal interest rates were not a sign that money was tight–that the central bank had pushed the market interest rate above the Wicksellian natural rate–but rather that money had been and probably was still loose, and that market expectations had adjusted to that.

Friedman did in fact make that claim. But… he was wrong.

Consider the Volcker disinflation. The Fed… did everything one might imagine to make it clear that there was a regime shift that would lead to disinflation…. This policy change nonetheless led to a severe recession… conclusive evidence against both the Lucas notion that only unanticipated monetary policy has real effects, and the Prescott view that business cycles reflect real shocks. But the episode also undermines the Friedman claim on interest rates…. Short rates… were sharply elevated for three years…. Long rates… rose along with short rates and stayed high for several years. So put yourself in the (very expensive) shoes of a bank CEO today…. Even if you understand the macroeconomics and know the history (which you probably don’t), this is a story about a better bottom line four or five years down the pike, by which time you will have foregone a lot of bonuses and may well be retired. As I see it, interest-rate hawkery on the part of bankers isn’t irrational, just evil.

Touché…

I confess I have been thinking that we have a choice between:

  • The Federal Reserve starts its liftoff this fall, and then has to reverse course within two yours back to the ZLB, thus cementing market expectations that we will be at the ZLB for a loooong time…

  • the Federal Reserve waits two years to start liftoff, and then successfully accomplishes normalization…

Paul says: It won’t be that quick. And the historical evidence is certainly on his side.

Plus: Dean Baker piles on:

Dean Baker: The Argument for Higher Interest Rates: Are the Bankers Evil or Stupid?: “I would mostly agree with Krugman, but for a slightly different reason…

…An unexpected rise in the inflation rate is clearly harmful to banks’ bottom line. This will lead to a rise in long-term interest rates and loss in the value of their outstanding debt…. While we (the three of us) can agree that such a jump in inflation is highly unlikely in the current economic situation, it is not zero. Furthermore, a stronger economy increases this risk….[Banks] are faced with a trade-off between a greater risk of something they really fear, and something to which they are largely indifferent. It shouldn’t be surprising that they want to the Fed to act to ensure the event they really fear (higher inflation) does not happen. Hence the push to raise interest rates.

I suspect also there is a strong desire to head off any idea that the government can shape the economy in important ways. There is enormous value for the rich to believe that they got where they are through their talent and hard work and that those facing difficult economic times lack these qualities. It makes for a much more troubling world view to suggest that tens of millions of people might be struggling because of bad fiscal policy from the government and inept monetary policy by the Fed.

Must-Read: Paul Krugman: Nutcases and Knutcases

Posted on by Brad DeLong

Must-Read: If you work really, really hard, you might be able to make something not completely unintelligible out of Andrew Sentance. You might agree with Paul Krugman that interest rates need to be even lower to provide people with an incentive to consume and invest at the economy’s sustainable non-inflationary potential. But you might go on to say that interest rates need to be higher to curb people’s desires to engage in overleverage, bubbles, and Ponzi schemes–that debts of extraordinarily long duration with extraordinarily low rates of amortization is asking for trouble.

But if you did that, you would be advocating not tight money but, rather, a higher inflation target. Amortization rates and durations of debt, you see, depend primarily on nominal interest rates. While the Wicksellian real rate to balance aggregate supply and aggregate demand and make Say’s Law true in practice is a real interest rate. And a higher inflation target is the way to make a bigger wedge between the two.

So even if you try really, really hard to make something not completely unintelligible out of Andrew Sentance, you conclude that he has no idea what he is talking about:

Paul Krugman: Nutcases and Knut Cases: “Monetary permahawkery takes two forms…

…One is obviously ridiculous… with a lot of influence on right-wing politicians… the likes of Ron Paul, Zero Hedge, and Paul Ryan. Hyperinflation is always just around the corner. And no matter how wrong the scare stories have been in the past, there’s always a willing audience.

But the clear and present danger comes from people like Andrew Sentance, who was until recently a member of the Bank of England’s Monetary Policy Committee… a remarkable piece… castigating the Fed for not hiking rates…. Sentanc[has] made up his own version of macroeconomics… unaware that he has done so. As I… [and] others, notably Ben Bernanke… point out… monetary wisdom… starts with Knut Wicksell’s concept of the natural interest rate. Try to keep rates too low, and inflation accelerates; try to keep them too high, and inflation decelerates and heads toward deflation. Now comes Sentance, claiming that monetary policy has been consistently too easy, not just in recent months, but for the past generation….

This should imply that policy has had an inflationary bias, right? Except that inflation has trended downward…. You might have expected at least some effort to explain why this isn’t a problem…. Sentance mocks the decision not to raise rates, suggesting that it has no real justification…. How about the fact that inflation is still below the Fed’s target, and shows no sign of rising? And that doesn’t even get into the argument, which Larry Summers, yours truly, and many others have made, that the risks of getting it wrong are highly asymmetric…. Maybe Sentance is right to toss almost everything economists have said about interest rate policy for the past 117 years out the window. But… it’s hard to escape the suspicion that he has no idea that this is what he’s doing. And he sat on the committee making British monetary policy!