Tag: Monetary Policy

Central Banks, Neutral Policy, and Economic Structure

Posted on by Brad DeLong

Since 2009 the Federal Reserve and other global north central banks have, first hesitantly and enthusiastically, been trying to sacrifice the health of the commercial banking sector in order to keep the life support machines that are keeping the rest of the economy alive going.

Your average commercial bank needs a 2.5% margin on its liabilities in order to cover the cost of its branches and its ATM network. Commercial banks are used to taking their deposits, sticking them in long term Treasuries and similar assets, and relying on time, diversification, the slope of the yield curve ,and the normal level of interest rates to generate the revenue so that they can earn profits if they manage their branches and ATM networks efficiently. Since 2008 that has not been a profitable strategy for commercial banks. Thus commercial banks have been under enormous pressure for a near-decade now.

It is there, I think, that central banks have been inflicting significant pain. It is not the case that extremely low interest rates on extremely safe assets has been keeping alive businesses that ought to shut down. For small businesses, credit is tight. Equity earnings yields are about normal–a company that is trying to think about whether to expand or payout its earnings is not facing any sort of environment in which there is a cost of capital that is in any sense “artificially low”.

So I do not see the Fed as having given any sort of pass to industry as a whole at all. It has kept the rest of the economy functioning while imposing very heavy pressures on the commercial banking sector. This is not normal. But it is not a bubble…

Should We Use Expansionary Fiscal Policy Now Even If the Economy Is at Full Employment? Yes!

Posted on by Brad DeLong

When should you use fiscal policy to expand demand even if the economy is at full employment?

First, when you can see the next recession coming: that would be a moment to try to see if you could push the next recession further off.

Second, if it would help you prepare you to better fight the next recession whenever it comes.

The second applies now whether we are near full employment or not. Under any sensible interpretation of where we are now, using some of our fiscal space would put upward pressure on interest rates and so open up enormous amounts of potential monetary space to fight the next recession. It would do so whether or not it raised output and employment today as long as it succeeded in raising the neutral interest rate–and if a large enough fiscal expansion does not raise the neutral interest rate, we do not understand the macroeconomy and should simply go home.

Fiscal Policy in the New Normal: IMF Panel

Note to Self: I Still Fail to Understand Ken Rogoff’s Medium-Long Term Macroeconomic Optimism…

Posted on by Brad DeLong

Ken Rogoff: “In nine years, nobody will be talking about ‘secular stagnation’. I’ve been debating Larry on this for a year, and I started saying ‘in ten years…, and so for consistency I now say ‘in nine years…”.

10 Year Treasury Constant Maturity Rate FRED St Louis Fed

This is a wager that the full-employment long-run in which money and its associates are a veil that does not affect or disturb the Say’s Law operation of the economy will come not more than 18 years after the shock of 2017–or at least that whatever remnants of the effects of that shock on the business cycle come 2025 will be dwarfed the effects of other business cycle shocks subsequent to now.

I do know from experience that one disagrees with Ken Rogoff at one’s grave intellectual peril. But is he correct here? I really cannot follow him to the conclusion he wants me to reach…

Things to reread and chew over:

  • Paul Krugman (2015): The Inflationista Puzzle: “Traditional IS-LM analysis said that the Fed’s [expansionary QE] policies would have little effect on inflation; 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…. I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009…”

  • J. Bradford DeLong (2015): New Economic Thinking, Hicks-Hansen-Wicksell Macro, and Blocking the Back Propagation Induction-Unraveling from the Long Run Omega Point

  • Paul Krugman (2015): Backward Induction and Brad DeLong: “Brad DeLong is, unusually, unhappy with my analysis in a discussion of the inflationista puzzle–the mystery of why so many economists failed to grasp the implications of a liquidity trap, and still fail to grasp those implications despite 6 years of being wrong. Brad sorta-kinda defends the inflationistas on the basis of backward induction; I find myself somewhat baffled by that defense…”

  • Paul Krugman (2015): Rethinking Japan: “Secular stagnation and self-fulfilling prophecies: Back in 1998… I used a strategic simplification… [assumed] the Wicksellian natural rate… would return to a normal, positive level at some future date. This… provided a neat way to deal with the intuition that increasing the money supply must eventually raise prices by the same proportional amount; it was easy to show that this proposition applied only if the money increase was perceived as permanent, so that the liquidity trap became an expectations problem… [so] that if the central bank could “credibly promise to be irresponsible,” it could gain traction even in a liquidity trap. But what is this future period of Wicksellian normality of which we speak?… Japan looks like a country in which a negative Wicksellian rate is a more or less permanent condition. If that’s the reality, even a credible promise to be irresponsible might do nothing…. The only way to be at all sure of raising inflation is to accompany a changed monetary regime with a burst of fiscal stimulus…. While the goal of raising inflation is, in large part, to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion. This isn’t at all a paradox, but it’s unconventional enough that one despairs of turning the argument into policy…”

  • Paul Krugman (2015): St. Augustine and Secular Stagnation: “The assumption here is that the neutral rate will eventually rise so that monetary policy can take over the job of achieving full employment. What if we have doubts about whether that will ever happen? Well, that’s the secular stagnation question… a situation in which the neutral interest rate is normally, persistently below zero. And this raises a puzzle: If we worry about secular stagnation, should we then say that St. Augustine no longer applies, because better days are never coming? No. The way to deal with secular stagnation, if we believe in our models, is to raise the long-run neutral interest rate…. If we can do this via structural reform and/or self-financing infrastructure investment, fine. If not, raise the inflation target. And how do we get to the higher target inflation rate, when monetary policy is having trouble getting traction? Fiscal policy! If you’re really worried about secular stagnation, you should advocate a combination of a raised inflation target and a burst of fiscal stimulus to help the central bank get there. So the St. Augustine approach is right either way, with secular stagnation suggesting the need to be even less chaste in the short run.”

  • J. Bradford DeLong (2015): Must-Read: Paul Krugman: Rethinking Japan: “Paul Krugman’s original argument assumed that the economy would eventually head towards a long-run equilibrium in which flexible wages and prices would make Say’s Law hold… [with] 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…. There is… more. Paul Krugman’s original argument also assumed back-propagation into the present via financial-market… and consumer-satisfaction intertemporal… 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…”

  • J. Bradford DeLong (2015): The Scary Debate Over Secular Stagnation: Hiccup… or Endgame?

  • Paul Krugman (2015): On Being Against Secular Stagnation Before You Were for It

  • Duncan Weldon (2016): Negative Yields, the Euthanasia of the Rentier, and Political Economy: “I understand the mechanics of engine that took us here but not what the driver was thinking…”

  • J. Bradford DeLong (2015): Just What Are the Risks That Alarm Ken Rogoff?: “This part of Ken Rogoff’s piece appears to me to be very much on the wrong track: ‘Ken Rogoff: Debt Supercycle, Not Secular Stagnation: Robert Barro… has shown that in canonical equilibrium macroeconomic models small changes in the market perception of tail risks can lead both to significantly lower real risk-free interest rates and a higher equity premium…. Obstfeld (2013) has argued cogently that governments in countries with large financial sectors need to have an ample cushion, as otherwise government borrowing might become very expensive in precisely the states of nature where the private sector has problems…’ We need to be clear about what the relevant tail-risk states that Ken Rogoff is talking about are…. [They are that] even though it was sold at a high price and carries a low interest rate, the issuing of government debt is very expensive to the government [because] when the time comes in the bad state of the world for it to raise the money to amortize the debt, it finds that it really would very much rather not do so. It is clear if you are Argentina or Greece what the risk is: it is of a large national-level terms-of-trade or political shock, something that you can insure against by investing in the ultimate reserves of the global monetary system. If you are the United States or Germany or Japan or Britain, what is the risk? What is the risk that cannot be handled at low real resource cost by a not-injudicious amount of inflation, or of financial repression?”

  • J. Bradford DeLong (2015): Watching a Discussion: The Omega Point

Note to Self: Inadequate Musings on Elements of Rogoff’s Debt Supercycle Hypothesis

Posted on by Brad DeLong
Real Gross Domestic Product for European Union 28 countries © FRED St Louis Fed

It is, once again, time for me to think about Ken Rogoff’s hypothesis: his claim that right now the world economy as a whole is depressed because we are in the down phase of a debt supercycle–dealing with a debt overhang.

I have never been able to make enough sense of Rogoff’s perspective here to find it convincing.

I should, however, warn people that when I fail to see the point of something that Ken Rogoff has written, the odds are only one in four that I am right. The odds are three in four that he is right, and I have missed something important:

One way to view the situation is that there have been four serious diagnoses of the ills of the Global North. They are:

  • A Bernanke global savings-glut.
  • A Krugman-Blanchard return to “depression economics”.
  • A Rogoffian-Minskyite crisis of overleverage and debt overhang
  • A Summers secular-stagnation chronic crisis.

The policies recommended by the different diagnoses do differ.

  • A Bernanke global savings-glut chronic crisis requires shifts in global governance that reduce incentives to run large trade surpluses and a redistribution of world income to those with lower marginal propensities to save.
  • A Krugman-Blanchard return to “depression economics” requires larger automatic stabilizers, a higher inflation target, and perhaps a return of fiscal policy to preeminence
  • A Rogoffian-Minskyite temporary crisis of overleverage and of excessive underwater debt requires debt writedowns and financial-intermediary recapitalizations.
  • A Summers secular-stagnation chronic crisis of insufficiently-profitable risk-adjusted investment opportunities requires a shift in responsibility for long-run expenditure from private to government–” a more-or-less comprehensive socialization of investment”, as some guy once wrote.

Let me put the other three to the side, and focus on Rogoff here…

A principal implication of Rogoff’s hypothesis is that, if it is true, that there is no complete and quick fix : recovery is inevitably a lengthy process–although good policies can accelerate and bad policies retard full recovery.

As I understand it, the down phase of what Ken Rogoff calls a debt supercycle can be generated by some or all of:

  • a collapse of market risk tolerance, or of trust in the credit channel, itself generated by one or more of:
    • a failure to mobilize society’s risk bearing capacity,
    • inadequate capitalization of financial intermediaries,
    • a collapse in the reputation of financial intermediaries: either trust that they are long-term greedy, or confidence in their competence, or both.
  • a rise in fundamental riskiness.
  • the past issue of too much risky debt.
  • the past issue of too much risky debt that has become or is now perceived to be risky.
  • a decline in expectations of how much future cash flow there will be available for potential debt servicing.

How long it takes to work off a debt supercycle and rebalance the economy depends on the speed of the processes of:

  • economic growth, which raises cash flow for potential debt servicing.
  • capital depreciation, which by raising the profit rate also raises cash flow for potential debt servicing.
  • debt write-offs.
  • the normal pace of debt amortization.
  • unexpected inflation writing down nominal debts.
  • other forms of financial repression.

As long as we remain in the down-phase of the debt supercycle, even low interest rates do little to encourage the investment spending needed to drive the economy to full employment. Why? Because investment spending requires not just positive expected value given the interest rate, but also the commitment of risk bearing capacity, which is absent because of the debt overhang.

My first reaction is that the right way to deal with this is to rebalance the economy by undertaking economic activities that do not require the deployment of risk bearing capacity to set them in motion. Governments with exorbitant privilege that have ample fiscal space should borrow and spend–most desirably on things that raise potential output in the future, but other worthwhile activities that create utility are also fine.

As I wrote: We have underemployment. We have interest rates on government debt and thus the debt amortization costs of the government far below any plausible rate of return on productive public investments (or, indeed, any plausible social rate of time discount geared to a sensible degree of risk aversion and the trend rate of technological progress). Under such circustances, at least reserve currency-issuing governments with exorbitant privilege should certainly be spending more, taxing less, and borrowing.

But Rogoff seems to disagree:

Kenneth Rogoff (2011): The Second Great Contraction: “Many commentators have argued that fiscal stimulus has largely failed… because it was not large enough…

…But, in a “Great Contraction,” problem number one is too much debt. If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions…. Governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation…. Europe could perhaps be persuaded to engage in a much larger bailout for Greece (one that is actually big enough to work), in exchange for higher payments in ten to fifteen years if Greek growth outperforms…

And:

Kenneth Rogoff (2015): world’s economic slowdown is a hangover not a coma: “Vastly increased quality infrastructure investment… a great idea. But… not… a permanently sustained blind spending binge…

…What if a diagnosis of secular stagnation is wrong? Then an ill-designed permanent rise in government spending might create the very disease it was intended to cure…. There can be little doubt that a debt super cycle lies behind a significant part of what the world has experienced over the past seven years. This resulted first in the US subprime crisis, then the eurozone periphery crisis, and now the troubles of China and emerging markets. The whole affair has strong precedent…. America’s experience–whether one looks at the trajectory of housing and equity prices, unemployment and output, or public debt–has uncannily tracked benchmarks from past systemic financial crises. This is not to say that secular factors are unimportant. Most financial crises have their roots in a slowing economy that can no longer sustain excessive debt burdens…

Rogoff seems to have a counter. He seems to think that borrow-and-spend by governments with fiscal space will, or perhaps may, lead, ultimately, to disaster. Why? Because the fiscal space was never really there. The increase in debt issue will transform even the government’s old safe debt into risky debt. And the overhang of risky debt will be increased, worsening the problem.

The counter to that, of course is helicopter money: money printing- and financial repression-financed expansionary fiscal policy rebalances the economy at full employment without any risk of incurring a larger overhang of risky debt further down the road.

And Rogoff’s response to that is… what?

Relevant:

Paul Krugman: Airbrushing Austerity: “Ken Rogoff weighs in on the secular stagnation debate, arguing basically that it’s Minsky, not Hansen…

…that we”re suffering from a painful but temporary era of deleveraging, and that normal policy will resume in a few years…. Rogoff doesn”t address the key point that Larry Summers and others, myself included, have made–that even during the era of rapid credit expansion, the economy wasn’t in an inflationary boom and real interest rates were low and trending downward–suggesting that we”re turning into an economy that “needs” bubbles to achieve anything like full employment. But what I really want to do right now is note… people who predicted soaring interest rates from crowding out right away now claim that they were only talking about long-term solvency… people who issued dire warnings about runaway inflation say that they were only suggesting a risk, or maybe talking about financial stability; and so on down the line…. In Rogoff’s version of austerity fever all that was really going on was that policymakers were excessively optimistic, counting on a V-shaped recovery; all would have been well if they had read their Reinhart-Rogoff on slow recoveries following financial crises. Sorry, but no….

David Cameron didn’t say “Hey, we think recovery is well in hand, so it’s time to start a modest program of fiscal consolidation.” He said “Greece stands as a warning of what happens to countries that lose their credibility.” Jean-Claude Trichet didn’t say “Yes, we understand that fiscal consolidation is negative, but we believe that by the time it bites economies will be nearing full employment”. He said: “As regards the economy, the idea that austerity measures could trigger stagnation is incorrect … confidence-inspiring policies will foster and not hamper economic recovery, because confidence is the key factor today.” I can understand why a lot of people would like to pretend, perhaps even to themselves, that they didn’t think and say the things they thought and said. But they did.

And this part of Ken Rogoff’s piece appears to me to be on the wrong track:

Ken Rogoff: Debt Supercycle, Not Secular Stagnation: “Robert Barro… has shown that in canonical equilibrium macroeconomic models…

…small changes in the market perception of tail risks can lead both to significantly lower real risk-free interest rates and a higher equity premium…. Martin Weitzman has espoused a different variant of the same idea based on how people form Bayesian assessments of the risk of extreme events…. Those who would argue that even a very mediocre project is worth doing when interest rates are low have a much tougher case to make. It is highly superficial and dangerous to argue that debt is basically free. To the extent that low interest rates result from fear of tail risks a la Barro-Weitzman, one has to assume that the government is not itself exposed to the kinds of risks the market is worried about, especially if overall economy-wide debt and pension obligations are near or at historic highs already. Obstfeld (2013) has argued cogently that governments in countries with large financial sectors need to have an ample cushion, as otherwise government borrowing might become very expensive in precisely the states of nature where the private sector has problems…

The Three Ways in Which the Post-Korean War Federal Reserve Reacts to/Leads Large Increases in the Unemployment Rate

Posted on by Brad DeLong
  • In “Eisenhower” episodes, the Federal Reserve cuts interest rates slowly and shallowly as the unemployment rises, trusting to the equilibrium-restoring self-stabilizing forces of the economy. It then raises interest rates as the economy recovers.
  • In “murder” episodes, the Federal Reserve kills the expansion in order to fight inflation. Interest rates start high when the unemployment rate starts rising, the Fed then cuts interest rates far and quickly as unemployment approaches its peak, after which it raises interest rates as the economy recovers.
  • In “financial crisis” episodes, a financial crisis (S&L 1990; dot-com 2000) sends the unemployment rate up, in response the Federal Reserve cuts interest rates substantially, and then raises them as the economy recovers.

    • Of course, post-2007 fits none of these patterns because of the zero lower bound…

    2016 10 04 Unemployment and Fed Funds Changes numbers 2016 10 04 Unemployment and Fed Funds Changes numbers 2016 10 04 Unemployment and Fed Funds Changes numbers

    DRAFT: Did Macroeconomic Policy Play a Different Role in the (Post-2009) Recovery?

    Posted on by Brad DeLong
    Federal reserve bank of boston Google Search

    J. Bradford DeLong
    U.C. Berkeley
    October 15, 2016

    Federal Reserve Bank of Boston
    60th Economic Conference
    The Elusive “Great” Recovery: Causes and Implications for Future Business Cycle Dynamics

    Abstract: How has macroeconomic policy been different in this recovery? In banking and regulatory policy, it has been distinguished from earlier patterns—or from what we thought earlier patterns implied for a shock this large and this persistent—in a relative unwillingness to apply the “penalty rate” part of the Bagehot Rule and in a slowness to restructure housing finance that are, for me at least, different than I had expected. In fiscal policy, the prolonged reign of austerity in an environment in which both classical and Keynesian principles suggest that it is time to run up the debt is surprising and unexpected, to me at least. In monetary policy it is more difficult to say what has been different and surprising in this recovery. There have been so many aspects of monetary policy and our expectations of what policy would be during a prolonged excursion to the zero lower bound that it is hard enough merely to say what monetary policy has been, and too much to ask how it has been different from whatever baseline view of what the policy rule would be that we ought to have held back in 2008.

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

    Posted on by Brad DeLong

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

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

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

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

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

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

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

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

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

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

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

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

    As Axel Weber remarked, afterwards:

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

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

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

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

    Martin Wolf: Man in the Dock:

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

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

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

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

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

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

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

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

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

    Axel Weber’s full comment:

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

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

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

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

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

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

    Posted on by Brad DeLong

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

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

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

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

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

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

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

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

    Sebastian Mallaby: The Doubts of Alan Greenspan:

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

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

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

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

    Greenspan:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

    Greenspan is not sounding the alarm.

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

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

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

    Mallaby continues:

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

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

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

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

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

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

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

    The Stakes of the Helicopter Money Debate: A Primer

    Posted on by Brad DeLong

    The swelling wave of argument and discussion around “helicopter money” has two origins:

    First, as Harvard’s Robert Barro says: there has been no recovery since 2010.

    The unemployment rate here in the U.S. has come down, yes. But the unemployment rate has come down primarily because people who were unemployed have given up and dropped out of the labor force. Shrinkage in the share of people unemployed has been a distinctly secondary factor. Moreover, the small increase in the share of people with jobs has been neutralized, as far as its effects on how prosperous we are, by much slower productivity growth since 2010 than America had previously seen, had good reason to anticipate, and deserves.

    The only bright spot is a relative one: things in other rich countries are even worse.

    The wave’s second origin comes in an institutional change that took place in rich countries around the year 1980, back in the era in which Paul Volcker took control of the Federal Reserve. Back then we changed our economic policy institutions. The stagflation of the 1970s convinced many that the political branches of government were incompetent at managing the business cycle. The business cycle disturbed inflation, unemployment, and short run growth. The political branches had tried to use the tools they controlled to manage the business cycle. The stagflation of the 1970s convinced many that they had failed and could not but fail. And the stagflation of the 1970s also convinced the political branches that they did not want responsibility for managing the business cycle—that to assume responsibility was to accept blame, because it would go badly.

    Thus back in 1980 Paul Volcker grabbed for the Federal Reserve the power they released. Henceforth the Federal Reserve—and its kith and kin central banks elsewhere in the world—were to be “independent”: They were to be effectively freed from meddling by vote seeking politicians with or seeking soundbites. They were tasked be good technocrats finding a way for the economy between the Skylla of inflation and the Kharybdis of unemployment. And thus they were to manage the economy generate stable, satisfactory, and equitable growth.

    But could the Federal Reserve and its kith and kin elsewhere do the job? Did they have the tools? Volcker’s view, and the consensus view of mainstream economists, was that they did have the tools: Milton Friedman had demonstrated, to the satisfaction of a rough consensus of mainstream economists, that central banks’ powers to create money with which to conduct financial open market operations and to both supervise and rescue the banking system were more than powerful enough to do the job.

    Now note that back in 1936 [John Maynard Keynes had disagreed][]:

    The State will have to exercise a guiding influence… partly by fixing the rate of interest, and partly, perhaps, in other ways…. It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself…. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative…

    By the 1980s, however, for Keynes himself the long run had come, and he was dead. The Great Moderation of the business cycle from 1984-2007 was a rich enough pudding to be proof, for the rough consensus of mainstream economists at least, that Keynes had been wrong and Friedman had been right.

    But in the aftermath of 2007 it became very clear that they—or, rather, we, for I am certainly one of the mainstream economists in the roughly consensus—were very, tragically, dismally and grossly wrong.

    Now we face a choice:

    1. Do we accept economic performance that all of our predecessors would have characterized as grossly subpar—having assigned the Federal Reserve and other independent central banks a mission and then kept from them the policy tools they need to successfully accomplish it?

    2. Do we return the task of managing the business cycle to the political branches of government—so that they don’t just occasionally joggle the elbows of the technocratic professionals but actually take on a co-leading or a leading role?

    3. Or do we extend the Federal Reserve’s toolkit in a structured way to give it the tools it needs?

    Helicopter money is an attempt to choose door number (3). Our intellectual adversaries mostly seek to choose door number (1)—and then to tell us that the “cold douche”, as Schumpeter put it, of unemployment will in the long run turn out to be good medicine, for some reason or other. And our intellectual adversaries mostly seek to argue that in reality there is no door number (3)—that attempts to go through it will rob central banks of their independence and wind up with us going through door number (2), which we know ends badly…

    [John Maynard Keynes had disagreed]: https://www.marxists.org/reference/subject/economics/keynes/general-theory/ch24.htm (John Maynard Keynes (1936): The General Theory of Employment, Interest and Money (London: Macmillan).

    Has Macro Policy Been Different since 2008?

    Posted on by Brad DeLong
    3 Month Treasury Bill Secondary Market Rate FRED St Louis Fed

    Was macro policy different after 2008? I interpret that to be the question: “Did macro policy follow the same rule after 2008 that people had presumed before 2008 it would follow in a true tail event?” To answer that question requires determining just what policy rule people back before 2008 thought that the U.S. government was following. Let me propose four candidates for our (implicit) pre-2008 macroeconomic policy rule:

    1. Limit fiscal policy to automatic stabilizers, and follow a Taylor rule with John Taylor’s coefficients (Taylor).
    2. Follow Milton Friedman’s advice and target velocity-adjusted money: if nominal GDP is below trend, print more money and buy bonds; if that does not restore nominal GDP to either the trend level or the trend growth rate (depending on whether your favorite flavor has or does not have base-drift sprinkles), repeat (Friedman).
    3. Use open market operations to manipulate the short-term safe nominal interest rate to stabilize inflation and unemployment as long as you are not at the zero lower bound. At the zero lower bound credibly promise to be irresponsible in the future in order to raise inflation expectations by enough to push the real interest rate down to its negative Wicksellian neutral rate value, and so restore real macroeconomic balance (Krugman).
    4. Use open market operations to manipulate the short-term safe nominal interest rate to stabilize inflation and unemployment as long as you are not at the zero lower bound. At the zero lower bound resort to expansionary fiscal policy and do as much of it as needed, at least as long as interest rates on long-term government debt remain low (Blinder).

    Were there any other live candidates for “the policy rule” back before 2008?