Is U.S. at Immediate Risk of Becoming “Argentina”?: Monday Smackdown/The Honest Broker for the Week of July 12, 2014

July 28, 2014

NewImageI have been waiting to post this until now, when there are only twelve months before the end date of my bet with Noah Smith on whether inflation would break 5% over any twelve-month period without a high-pressure labor market. I took the “no”. He took the “yes” and did so, from my perspective, irrationally–he only took 50-1, while he should have demanded odds an order of magnitude greater. That the final twelve-month window of our bet is now running means it is time to set out my thoughts on the trahison des clercs of so much of the academic economics profession over the past seven years.

The way I put it is this: We academic economists knew what to do do deal with the financial crisis that started in 2007 and to quickly restore normal levels of output relative to potential and of potential output growth. It was (a) not to do what Japan did in the 1990s, and (b) take the advice of a long line of policy-oriented economists starting from the Say-Malthus debate of the 1810s and 1820s (which Malthus won) and continuing through Mill, Bagehot, Wicksell, Keynes, Minsky, Kindleberger, Tobin, and many many others about what caused and how to deal with a “general glut”. But even though we knew what to do, we were not allowed to speak with one voice. Other academic economists–including many whom I formerly counted as of note and reputation–elbowed their way into the debate. They had either never bothered to learn the literature from Malthus to Tobin, had forgotten it, or were blinded by ideology. They reached for simplistic models and methods that were clearly wrong: (a) a crude quantity theory by which spending was proportional to the money stock and deviations of velocity from its technological trend were temporary–neglecting what John Hicks wrote in 1937 that “on pure value theory the sacrifice… [of] holding… money is a sacrifice of interest, and it is hard to believe the marginal principal does not hold”–(b) an even cruder fiscal theory of the price level, (c) a crude Lafferism by which very small changes in net-of-tax rates were supposed to have effects on potential output two orders of magnitude larger than anything in the literature, (d) an even cruder belief that operating business confidence was the key variable in the business cycle and depended on little other than confidence in balanced-budgets, or (e) the Method of Colonel Kurtz–that is, the only rational response is that of Captain Willard: “I don’t see any method at all, sir.”

First, an item of business:

I hereby announce that I wish to change the terms of my bet with Noah Smith on U.S. inflation, and whether the U.S. is at immediate risk of becoming “Argentina”:

“IF at any time between 7/28/2012 and 7/28/2015 core consumer prices, as recorded in the FRED database series CPILFESL, are up more than 5% in the preceding 12 months, and if over the same 1-year period monthly U3 unemployment (as recorded in FRED database series UNRATE) has not averaged below 6%…

…THEN Brad DeLong agrees to buy Noah Smith one dinner at Zachary’s Pizza at 1853 Solano Ave. in Berkeley CA, and to pay Noah 49 times the cost–including tax but excluding tip–of Noah’s meal at Zachary’s in Federal Reserve notes, or in alternative means of payment accepted by Zachary’s should Zachary’s Pizza no longer be accepting Federal Reserve notes at the date of the dinner. This cost will be assessed as the total cost of the dinner to all, divided by the number of people present, regardless of how much pizza is consumed by or how much alcohol is drunk by specific individuals. If however, the above condition is not satisfied, Noah agrees to buy Brad one dinner at Zachary’s.

Miles Kimball will be the judge in charge of refereeing the bet. The decisions of the judge will be final and unappealable.

Furthermore, Noah’s brave and gracious willingness to take the John Cochrane-Argentina side of this bet at odds of only 50-1 will not be construed as a statement of his confidence in or of his support for any economist or position of economic analysis that judges expansionary fiscal policy at the zero lower nominal interest rate bound to be “insane”, or that judges “1932” to currently be a less dire risk for the U.S. than “Argentina”.

The Zachary’s Pizza on College makes better pizza than the Zachary’s Pizza on Solano. I do note that the last twelve-month period in which Noah Smith might possibly win his pizza bet starts now. And I do note that his bet was irrational–that in my view producing an inflation rate more than 5%/year by 2015 without a high-pressure economy would have most likely required a supply shock twice as big as those of 1973 and 1979, and the odds against such a thing were not 50-1 but considerably greater.

This is of interest to me because I now have the prospect of free pizza and good dinner-time company in a little more than a year.

I have written about this before:

As has Noah:

This is of interest to you because there are still, even now, even after seven years of this, a lot of people out there who think the big danger facing the U.S. economy is not the Lost Decade (or more) that we are now 70% of the way through, but rather a sudden outbreak of inflation.

Now let me next set out what a rational analysis of our situation would be.

Walras’s Law tells us that expenditure has to be equal to income: people take the resources they have–including what they have socked into their mattresses–plus their income and have to do something with it–either socking it away in the mattress or using it to buy or to keep holding something. Thus you can only have a general glut–an excess supply of currently-produced goods and services, high unemployment, idle factories that are cost-effective in normal times, etc.–if there is an excess demand for something else. And your general glut can only be persistent if there is something that keeps the price of that “something else” wedged–that keeps the price of what is in excess demand from rising fast quickly relative to the prices of other commodities and so quickly ironing-out the excess demand and the general glut of currently-produced goods and services that is its Walras’s Law counterpart. Conversely, you only get rising inflation–the opposite of a general glut of currently produced goods and services–(a) when inflation expectations become de-anchored and rising inflation is a self-fulfilling prophecy, (b) when some adverse supply shock reduces potential output substantially or some sharp capacity constraint stops actual output growth, or (c) when there is an excess supply of something else. And in both cases the “something else” is some set of financial assets, invariably or almost invariably including as its main or one of its main components the liquid money stocks that greases the economy.

The Malthus-Tobin line of analysis thus has been asking always–especially over the past seven years–two questions:

  1. Where is there the potential for an excess demand for financial assets whose prices can wedge themselves and fail to adjust and so cause a general glut?
  2. Where is there the potential for rising inflation–either in deanchored expectations, sharp capacity constraints, or an excess supply of financial assets whose prices can wedge themselves and fail to adjust and so cause too much money to chase too few goods?

The answer to (1) is and has been obvious. The collapse of the housing bubble in an environment of gross overleverage produced (a) a collapse in risk-tolerance and thus a great increase in the desire to hold safe assets, (b) an enormous reduction in the supply of assets seen as safe, (c) a wedged price of safe assets produced by their inability to go to more than par–the zero lower bound on safe short-term nominal interest rates, you know–and thus (d) a general glut.

The answer to (2) also is and has been obvious. Nowhere. Inflation expectations are well-anchored. There are no signs of supply shocks or of hitting capacity constraints in natural resources, in industrial capacity, or in labor markets. And there is no sign that the Federal Reserve intends to or might accidentally or would even tolerate any pegging of any possible market rate of interest below the natural Wicksellian rate and so creating an excess supply of finance.

And yet I still hear–over and over again, from place after place, as I have heard every single year since 2007–that the Federal Reserve is dangerously behind the curve and that an outburst of inflation is in our future. The method is, variously:

  1. The crude quantity theory that looks at the very large money stock, and claims that must be an excess supply–without bothering to look at what is going on in the rest of asset markets that boosts and is expected to boost demand for the large money stock that the Federal Reserve has reluctantly supplied.
  2. The even cruder fiscal theory of the price level by which the real debt capacity of reserve currency-issuing sovereigns is tightly limited–a point of view that fails to acknowledge the extraordinary exorbitant privilege that reserve currency-issuing sovereigns have.
  3. An even cruder Lafferism by which very small changes in net-of-tax rates are supposed to have effects on potential output two orders of magnitude larger than anything in the literature.
  4. An even cruder confidence–without any evidence whatseover– that business confidence is about to collapse and de-anchor inflation expectations.
  5. But usually the method of Colonel Kurtz (in the movie, not the book): that is, no method at all.

Here are three of the less irrational examples:

From the Cato Institute–of which I used to expect better:

Gerald P. O’Driscoll: Where’s the Inflation? Coming to Your Neighborhood: “In December 2008, the Federal Reserve drove down the overnight federal funds rate to near zero. In March 2009, it announced an aggressive program to purchase mortgage backed securities… successive rounds of monetary easing… unprecedented in size and scope. Economists have been predicting an outbreak of inflation. Were they wrong? Critics say the absence of inflation proves the doomsday forecasts were wrong. Some critics, like Paul Krugman, argue even more monetary stimulus is needed….

Prices are rising faster than the CPI suggests…. The process of reserve creation should in normal times have led to rapid growth in money, and then price inflation. Based on history and theory, the predictions were sound. The deleveraging process put a spanner in the works of money creation…. There has been money growth. The 12-month growth rate as of April 2013 for M1… was about 12%; the 12-month growth rate for M2… was 7%…. And there has been price inflation, here and around the world….

CPI (or alternate measures of consumer prices) have not been accurate gauges of monetary stimulus for decades…. In an inflationary episode, prices of goods often increase sequentially, and not in tandem…. Home prices are once again on an upward march, and we will see whether the Fed is helping inflate another housing bubble…. Bond prices are a bubble from any historical perspective. I leave it to the readers to exercise their own judgments on equity prices…. Monetary expansion has effects beyond domestic consumer prices. There is no presumption that an expansionary monetary policy affects consumer goods prices first. Inflation is already here, and more is coming to your neighborhood soon. If the past is prologue, the Fed will wait too long to react to inflation.

From Peter Schiff, of whom I never expected better:

Peter Schiff: Yellen: Where No Man Has Gone Before: Janet Yellen… is very different from any of her predecessors… the most dovish and politically leftist Fed Chair in the Central Bank’s history…. She does not seem to see the Fed’s mission as primarily to maintain the value of the dollar, promote stable financial markets, or to fight inflation. Rather she sees it as a tool to promote progressive social policy and to essentially pick up where formal Federal social programs leave off…. [Yellen] likely has a greater understanding of how the Fed’s monetization of government debt (through Quantitative Easing) has prevented the government from having to raise taxes sharply or cut the programs she believes are so vital to economic health. But as these policies have also been responsible for pushing up prices for basic necessities such as food, energy, and shelter, these “victories” come at a heavy cost. Recent data shows that consumers are paying more for the things they need and spending less on the things they want. But Yellen simply brushes off this evidence as temporary noise….

If Yellen and her dovish colleagues do not receive the kind of open-ended international support that we have enjoyed thus far in 2014, the full inflationary pain of her policies will fall heaviest on those residents of Main Street for whom she has expressed such deep concern…

From Larry Kudlow:

Larry Kudlow: Fed’s Talk Of Low-Flation Is Dangerous Nonsense: If today’s 1 percent inflation rate continued for 25 years, you’d have a 28 percent inflationary hike. But if you move to a 2 percent yearly inflation rate, which is what some Fed people seem to be targeting, wage earners and all the rest of us would experience a 64.1 percent compounded, cumulative inflation rise over 25 years. At 2.5 percent inflation, which is what some other Fed folks are saying, we would experience an 85.4 percent inflation gain over the next quarter century.

Is that what we really want? Is the central bank willing to take that risk? Don’t they know that historically a little more inflation turns into a lot more inflation, which then goes out of control?… Janet Yellen is using the wrong model…. Forward-looking market-price signals, such as gold, commodities, the Treasury yield curve, and the dollar exchange rate are recently showing a tiny bit of inflation risk, but not very much. These are the indicators the Fed should watch–not the unemployment rate or a basket of other labor indicators…. And while we’re at it, let’s keep the dollar sound. In fact, I’d like to see King Dollar appreciate by 10 to 15 percent…. Get rid of QE3, move to the 1.5 percent Taylor rule fed funds rate, and institute pro-growth economic reforms. This policy package will keep inflation low and drive economic growth higher. It worked in the ’80s and ’90s. But it’s been forgotten in recent years…

Plus, of course, there are the unhinged howlings from the Fever Swamp:

Newsweek:

Niall Ferguson: The Great Inflation of the 2010s: ‘I can’t eat an iPad.’ This could go down in history as the line that launched the great inflation of the 2010s…. William Dudley, was trying to explain to the citizens of Queens, N.Y., why they had no cause to worry about inflation. Dudle… put it this way: ‘Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful. You have to look at the prices of all things.’ Quick as a flash came a voice from the audience: ‘I can’t eat an iPad.’… The Fed… points to the all-urban consumer price index (CPI-U)…. To ordinary Americans, however, it’s not the online price of an iPad that matters; it’s prices of food on the shelf and gasoline at the pump…. The CPI is losing credibility… as economist John Williams tirelessly points out, it’s a bogus index…. Double-digit inflation is back. Pretty soon you’ll be able to figure out the real inflation rate just by moving the decimal point in the core CPI one place to the right…. Maybe high fuel prices will, as Goldman Sachs predicts, slow the economy and revive the specter of deflation. Maybe. Or maybe inflation expectations started shifting when the guy from Goldman—a Marie Antoinette for our times—seemed to say: let them eat iPads!

Red State:

Erick Erickson: The Real World and the Chart: Paul Krugman wishes to disprove something I wrote the other day…. Krugman uses a chart to try to disprove the reality that Americans with small kids actually experience at the grocery store. It’s written like a man who does not have kids at home…. If he hung around moms and dads with kids more often he’d hear a lot more real world complaining about the cost of bread, milk, and other grocery item prices going up while paychecks are staying the same…. It is an ongoing issue and has been since late in the Bush Presidency when these conversations became more routine at the playground and around the dinner table with friends. Not everything is academic or chartable and sometimes the accuracy of the chart isn’t as real to people as the perception they have that their grocery store bills are getting more expensive though their shopping habits haven’t changed. That’s the point, Paul, but I appreciate the charts. Next time another parent brings this up, I’ll be sure to pass along the chart and tell them to look at that, not their grocery bill…

National Review:

Amity Shlaes: Inflation Vacation: There’s one nuisance that can interrupt your seven-day idyll… the price zap…. Your daughter wants a haircut… $45…. What? A haircut used to be $20…. A gallon of gas is $4.00, when it was $1.30 back in 2000. You expected gas to be high. But not this high…. The ticket is $10.00, not $5.00, like it was when you went to see Gladiator back in 2000…. Coffee. A pound is $5.20, not $3.40…. Your pay certainly hasn’t doubled since 2000, like the price of the movie ticket….

All the official numbers, especially the Consumer Price Index, say that inflation is reasonable…. Janet Yellen, the new Fed chairman, says she’s not worried. Maybe she will have a good vacation. But other numbers suggest that inflation is higher than what the official data suggest…. John Williams[‘s] contention is that several alterations in the way we measure inflation have caused distortion…. Which takes us back to Rick Santelli. What Santelli is really talking about is getting the Fed back to a point where it cares about inflation. If you study the… video, where the CNBC host gets bullied into silence by Steve Liesman, you’ll see the problem. The price today for talking about inflation is itself too high. Santelli doesn’t really need a vacation, but he sure deserves one. Then he and maybe some others can return to argue again. It’s time for a real debate on inflation to commence…

The American Thinker:

Rich Danker: Janet Yellen and the Phillips Curve: Janet Yellen, a disciple of predictive modeling, dismisses the notion that the Fed could go too far. To her the record shows that ‘tuning works even if it is not “fine”‘… the belief that economic policymaking is the practice of top-down management of the economy, informed by the assumed tradeoff between inflation and unemployment. It isn’t just the 1970s, but the last few years, that show how money creation does not produce permanent employment gains. This was raised time and time again at Yellen’s recent Senate Banking Committee hearing, when several Democrats bemoaned the absence of any “trickle down” effect from quantitative easing. Do we want the Fed to double-down on that folly with Janet Yellen at the helm?…

The Federalist:

Sean Davis: American Families Are Right To Be Worried About Inflation: The subtext to all of the inflation critiques from the likes of Perry, Pethokoukis, and Ponnuru is that we should leave the Federal Reserve alone. Stop blaming the Fed for inflation, you guys. Please ignore that QE, QE2, QE3, and a multi-year zero interest rate policy, etc. were all intentionally designed to increase inflation, you guys. Just ignore all the different goods for which prices are rising really rapidly, you guys. Ignore the fact that higher prices and middling wages are eroding standards of living, you guys…

And, of course, ZeroHedge:

ZeroHedge: The Fed Just Lost Any Shred of Credibility on Inflation: [Janet yellen] has got to be the most dovish Fed chairperson in the history of the institution going into the most important policy initiative withdrawal phase ever to be recorded since the inception of the Federal Reserve! She will probably step down in a year at this rate, as she obviously was the wrong person for the job!… We are now going to have to resurrect Paul Volcker`s spirit to the Federal Reserve to dig us out this hyperinflation mess, once inflation I mean Noise gets so unbearable that Janet Yellen is forced to embarrassingly resign by the president as the bond market takes matters into its own hands!…

Janet Yellen and the Federal Reserve are so behind the inflation curve, and many other market implication curves, that we probably are staring at a 35% chance of a Hyper-Inflationary period by the time the Federal Reserve realizes that Noise is actually real inflation! The surprising thing is that she backed herself into a corner on the data, and I expect the inflation and employment data to keep coming in much hotter and well ahead of the Feds own forecasts, and she didnt even leave herself any real wiggle room. With each new data point she and the Fed are going to look increasingly out of touch and well behind the curve that it is going to be shockingly laughable. If the sky is cloudy gray, and you keep saying that the sky is clear blue, people are going to stop listening to what you have to say…. The loss of credibility is by far worse than the actual policy decisions at this point, and after listening to Janet Yellen`s press conference, I am not sure she is a rational, logical, empirical thinking human being with her ridiculous comments regarding the stock market and inflation as she seems borderline senescent and incapable at best, and there is no doubt she is completely over her head at the Fed in this powerful position. I cannot wait to hear the Fed minutes of this latest Fed Meeting!

There is no hope for an elegant exit now from this monetary experiment, inflation will be at 4.5% before they even start raising rates! The bond market will be so far ahead of the Federal Reserve in terms of bond vigilantism that they are what will bring the Fed to finally realize that they have lost control of financial markets, and then it is endgame for interest rates! Once the bond vigilantes take control of markets because they have no faith in the Federal Reserve, it is time to seriously reevaluate what the makeup and role the Federal Reserve should play in future monetary decisions going forward!…

And this infects those who seek above all to be very very “balanced”. Three examples:

Bloomberg News:

Yuval Rosenberg: The Metaphor That Dramatically Captures Janet Yellen’s Interest Rate Dilemma: “Janet Yellen… remains very much in the hot seat. As the Fed winds down its bond-buying stimulus program… and with inflation edging higher…. Yellen, in her testimony, burnished her dovish credentials by suggesting the Fed still has more work to do before it turns to tightening…. Critics worried about the those risks and the disruptive market effects of the Fed’s ultra-low interest rates, including some of Yellen’s fellow Federal Reserve officials, have been arguing that the Fed should act sooner…. Otherwise, the Fed could be inflating bubbles that could threaten to again destroy… economic stability and improvement…

Dallas Federal Reserve Bank President Richard Fisher:

Richard Fisher: Monetary Policy and the Maginot Line: Given the rapidly improving employment picture, developments on the inflationary front, and my own background as a banker and investment and hedge fund manager, I am finding myself increasingly at odds with some of my respected colleagues…. The Fed as the nation’s monetary authority has been running a hyper-accommodative monetary policy… [boosting] the Fed’s balance sheet to $4.5 trillion… 75 percent of Federal Reserve-held loans and securities have remaining maturities in excess of five years, and we own roughly 40 percent of the stock of U.S. Treasury bonds and a similar proportion of MBS. This is an unprecedented profile…. To get a sense of some of the effects of excess liquidity, you need look no further than Neil Irwin’s front-page, above-the-fold article in the July 8 issue of the New York Times, titled “From Stocks to Farmland, All’s Booming, or Bubbling.” “Welcome to … the Everything Bubble,” it reads. “Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.”…

There are some who believe that “macroprudential supervision” will safeguard us from financial instability. I am more skeptical…. There is a legitimate question as to whether these safeguards represent no more than a financial Maginot Line, providing us with an artificial sense of confidence…. One has to consider the root cause of the “Everything Boom.” I believe the root cause is the hyper-accommodative monetary policy of the Federal Reserve and other central banks…. At some point you cross the line from reviving markets to becoming the bellows fanning the flames of the “Booming and Bubbling” that Neil Irwin writes about. I believe we have crossed that line. I believe we need an adjustment to the stance of monetary policy…. My sense is that ending our large-scale asset purchases this fall, however, will not be enough…. A bourbon addict doesn’t go from Wild Turkey to cold turkey overnight…. I believe the time to dilute the punch is close upon us…

The National Journal:

Michael Hirsh: How Janet Yellen’s Agenda Could Transform Washington: Janet Yellen… [is] the product of an old progressive tradition of activist, pro-government economics… represents a strain of interventionist thinking that has not found expression at such a high level in Washington in decades–at least since Ronald Reagan and his Milton Friedman-inspired attempt to shrink the size of government…. Yellen already appears to be settling the Fed’s eternal debate about the relative threats of unemployment and inflation; she declared bluntly in her testimony that joblessness is the issue of the moment….

Already she is describing the central bank’s job in ways that have stunned some traditional Fed watchers—and made them uneasy. Yellen’s very first statement after Obama nominated her in October suggested she intends to extend Bernanke’s revolutionary expansion of the Fed’s role, not ratchet it back. “While we have made progress, we have further to go,” she said, adding that the Fed’s job was not just to keep the dollar sound but “to serve all the American people … [and] ensure that everyone has the ability to work hard and build a better life.” The statement, which indicated that Yellen is focused on boosting employment, “knocked me over. It was a political statement which fits perfectly with her [academic] upbringing,” says David Jones, a veteran Fed analyst and the author of the forthcoming book Understanding Central Banking: The New Era of Activism.…

By her own account, Yellen represents the government-activist “Yale School” of economics, which believes that there are “clear answers to key questions dividing macroeconomists, along with policy prescriptions,” as she put it in a 1999 speech at Yale. “Will capitalist economies operate at full employment in the absence of routine intervention? Certainly not. Are deviations from full employment a social problem? Obviously.” She is, more than previous Fed chiefs, an old-style “hydraulic Keynesian” who believes she can act as a control engineer over the economy…

The net result of all of this is our economic policy discussion is much more focused than it should be on avoiding inflation dangerous that simply do not threaten, and much less focused than it should be on further policies to boost aggregate demand; to recoup some of the enormous investment gap in private business, government infrastructure, and human capital investment that has emerged; and to unwedge asset markets that are still profoundly dysfunctional both in mobilizing society’s enormous potential tolerance for holding diversified risky investments and improperly classifying, diversifying, and managing risks in order to restore credit access to all those now rationed out of the capital markets who should not be. And one cause of this is the trahison des clercs we saw–from people who really should have known better.

Let me give three examples from the truly remarkable and extraordinary day-long conference that Sebastian Mallaby put together in March of 2009. All three of these economists should, I think, really not have said what they said. And all three, I think, owe us an intelligible explanation of just what they were thinking and why–and why they were so wrong. And while it is always possible that I have missed it, none of the three has offered any intelligible admission of error, explanation of their thinking, or–and here I am aware that I am asking too much–any marking of their beliefs to market.

We heard from Robert Lucas:

Robert Lucas: Why a Second Look Matters: “I’ve been going to all the sessions…

…and it’s a great conference.  My head’s spinning.  Some of you will probably hear some of your best lines in my talk, for that matter…. One of the lessons of the Great Depression… is that a side effect of depression is a proliferation of ill-conceived, hastily put together policies that serve to postpone the recovery. By 1940, seven years after the 1933 trough, the U.S. economy still had not gotten back to 10 percent below trend….

The more urgent task of organizing our thinking about what, if anything, should be done right now to deal with the recession.  So I’m going to… just think about the basic arithmetic of what we might call–and this is a–the due irony–‘monetarist fine tuning.’…  

When it began [in 1930], it was a reduction in velocity, a ‘flight to cash’…. Now, the Fed could have responded to that situation by… creating the reserves… to supply the added liquidity…. But the Fed didn’t do anything to relieve this liquidity. They sat by. And they cut interest rates to zero. They were, I guess, the believers that… once interest rates get to zero, you’re over….

Now, the additional reserves the Fed has put into the system have induced double-digit growth in M1 and M2 domain monetary aggregates. And these are rates which, I think if they were sustained, would soon yield inflation at 1970s levels or higher.  And, moreover, as confidence returns, which it will, velocity is going to return to pre-crisis levels and people are going to start spending more out of their cash balances.  So, inflation’s going to–that too is going to add to the inflationary pressures. So, it’s absolutely necessary for the Fed to be able and willing to reverse course and sell off the assets…. I don’t see any reason to start cutting back now…. But, it’s something you might as well think about it because we’re going to get there….

We had some lively sessions this morning about fiscal stimulus.  Now, would a fiscal stimulus somehow get us out of this bind, or add another weapon that would help in this problem?… I just don’t see this at all. If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy. We don’t need the bridge to do that. We can print up the same amount of money and buy anything with it.  So, the only part of the stimulus package that’s stimulating is the monetary part….

But if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder–the guys who work on the bridge–then it’s just a wash.  It has no first-starter effect.  There’s no reason to expect any stimulation.  And, in some sense, there’s nothing to apply a multiplier to.  (Laughs.) You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that….

Christina Romer–here’s what I think happened. It’s her first day on the job and somebody says, you’ve got to come up with a solution to this–in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.

So she scrambled and came up with these multipliers and now they’re kind of–I don’t know. So I don’t think anyone really believes. These models have never been discussed or debated in a way that that say–Ellen McGrattan was talking about the way economists use models this morning. These are kind of schlock economics…

We heard from Ed Prescott:

Ed Prescott: The 1920s: Bubble, Growth, or Gold?: “The period of the ’20s was one of healthy growth…

…until Hoover’s anti-market, anti-globalization, anti-immigration, pro- cartelization policies were instituted, brought this expansion to an end, and created a great depression.  Roosevelt’s policies prolonged the Depression for over six additional years….

What about the great U.S. depression?  Well, you can depress an economy two ways. You can depress productivity–output per hour–or you can depress the number of hours worked per working-age person. The big thing in the Depression was not the productivity. Productivity was quite healthy. Growth was healthy during that decade…. High tax rates were not the problem in the ’30s.  We looked at that, and that’s only a small part.  Has to be something else. What’s that something else?  There’s really only one candidate that I know of that is consistent and–theoretically and empirically, and that is the Cole and Ohanian cartelization policies. I emphasize lack of government spending was not the reason for the big fall in employment. But the economy only recovered and it started recovering in 1939, when there’s a major shift in policies. That was the year when Roosevelt said the New Deal is dead. That was the year he called up the businessmen who had fled to England because–and said please come back; we got to get ready for war. It was not expenditures….

What about my predictions for the United States now? Last–the growth from 2007 to 2008, fourth quarter over fourth quarter, was 1 percent. In the Great Depression we had about four years where the growth rates were minus 5 or 6 or 7 percent. This is plus 1.  It would have been normal year if it was not for that fourth quarter…. I do predict the U.S. will lose a decade of growth…. Why?  Marginal tax rates will be increased. The productivity–depressing policies will be adopted in this country. A lot of people don’t know the current administration has abandoned the use of cost-benefit analysis by rescinding the 1981 executive order requiring all regulations to be evaluated before being implemented…

John Cochrane:

John Cochrane: The New Financial Deal: “The danger now is inflation…

…And I would say it’s a greater danger than most of the other people have said.  Our danger now is a run on Treasury debt.  It’s not just can the Fed soak this stuff back up again, but can it soak this enormous amount of debt back up again when people don’t want either money or Treasury bills or anything labeled ‘U.S. Government.’ The danger is not 1932; the danger is Argentina, a massive run from Treasury debt.  And then monetary policy will not be able to do anything. You can fool around with interest rates all you want.  When people don’t want Treasury bills or money you’re stuck.

Banks…. Unfortunately, I think we’re in the danger of fighting the last war here.  Bernanke has said, no large bank or financial institution will fail. We’re in the business of an astonishing bailout and credit guarantee, unimagined by the Great Depression…. Now, nobody in the Great Depression–we don’t–some of our essential problems we don’t have a historical antecedent for.  Nobody was fooling enough to think that toxic assets were the problem or that the government, by somehow stirring up the liquidity of $10 trillion of toxic assets, was going to make the banks look all right again.  This is an amazing fairy tale we’ve been telling ourselves for eight months now.  Think of every step of the chain. Stirring the pot is going to make everything more valuable. Making everything more valuable is going to make the banks look solvent again. Making the banks look solvent again means people are going to start buying bank stocks. Banks are just dying to go and lend if only they had more equity–it’s not just going to happen.  Well, that one we’re inventing on our own….

There’s almost no economics that describes how the Federal Reserve, by monkeying around with three months of Treasury bills and reserves, can lower long-term interest rates, but absolutely no economics that says how the Federal Reserve is in charge of the risk premium, and that’s what was going on. People were willing to hold mortgages, stocks, risky bonds at amazingly low premiums on the way up and now they want very high premiums on the way down.  That’s not something the Federal Reserve is in charge of….

General–well, a last couple of general comments.  Many things are depressingly the same.  Policy is chaotic.  Who would invest in this climate? It’s not about toxic assets; it’s about who wants to go in on a deal with Darth Vadar, who can change his mind at any moment? That’s the uncertainty that’s keeping things from getting going and that’s what’s slowing the rebuilding of financial markets. We’re facing growth-destroying marginal tax rates, an excuse for the government takeover of large and completely unrelated sectors, class warfare, vindictive ex post taxations. This is the chance for a credit crunch–which normally resolves itself fairly quickly–to turn into a Great Depression. 

And perhaps most of all there is the danger of learning the wrong lessons; that our grandchildren will have to come back to the next meeting to say, what were the lessons–the lessons mis-learned of the last time around?

My great hope is that the bounce-back will be quick before the quack medicine can be said to have worked. (Chuckles.) Just as we sort of–as people think that this insane idea of fiscal stimulus–which I’ll go on with later if I get a chance–came from Roosevelt’s experience with no reason why it should work, there is a danger of thinking all of the crazy stuff they’re doing now will have caused the bounce-back, if that happens, in five years, but my only hope is that it happens quickly and doesn’t leave us with another Great Depression…

And do note that these three are not unrepresentative. As just one of many additional examples, consider also the usually sharp-witted Martin Feldstein writing in April 2009:

Martin Feldstein: Inflation is looming on America’s horizon: The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation…. There is ample historic evidence of the link between fiscal profligacy and subsequent inflation. But historic evidence and economic analysis also show that the inflationary effects can be avoided if the fiscal deficits are not accompanied by a sustained increase in the money supply and, more generally, by an easing of monetary conditions…. The potential inflationary danger is that the large US fiscal deficit will lead to an increase in the supply of money…. Now the large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves….

The link between fiscal deficits and money growth is about to be exacerbated by ‘quantitative easing’…. This… cannot be distinguished from a policy of directly monetising some of the government’s newly created debt…. The Fed is also creating a massive increase in liquidity by its policy of supplying credit directly to private borrowers…. When the economy begins to recover, the Fed will have to reduce the excessive stock of money…. This will not be an easy task…. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation…

I found–I still find–this last particularly surprising, because it was Marty who back in the spring of 2009’s instantiation of Econ 2010c taught me to read very carefully James Tobin on asset demand, and how asset markets could become truly pathological at very low interest rates.

Still, only last month:

Martin Feldstein:* Warning: Inflation Is Running Above 2%: Inflation is rising in the United States and could become a serious problem sooner than the Federal Reserve and many others now recognize. There are three basic reasons why the Fed is too optimistic…. First, data indicate that prices are already rising faster than 2% and have accelerated in recent months. Second, the low rate of short-term unemployment may be creating pressure for faster inflation…. And third, the rhetoric of Fed officials indicates that the central bank may not react quickly and aggressively enough if inflation continues to rise above 2%….

Recent price increases may be a temporary surge that will recede in the months ahead. But they could be a response to increased demand…. Although the level of real GDP fell from the fourth quarter of 2013 to the first quarter of 2014, in the most recent three months real consumer spending rose at a 4% annual rate.

Will unemployment limit wage inflation?…. Because the long-term unemployed are less connected with the active job market, they may provide less downward pressure on wage inflation…. Is the Krueger research an accurate warning that labor markets are now closer to the threshold at which inflation begins to rise despite the substantial total number of people who aren’t working? By the time we do know if he’s right, it may be much more difficult to contain inflationary pressures.

More generally, Federal Reserve officials have made statements that suggest the Fed may not act quickly and strongly enough to limit a rising rate of inflation. Mr. Dudley expressed a common Fed opinion when he said recently that he believes the federal funds rate will rise relatively slowly…. A misinterpretation of labor-market slack, and a failure to create a positive real federal-funds rate, could put the economy on a path of rapidly rising inflation.

As I understand–and everybody else I talk to here at Berkeley at least understands–William Dudley, his belief that the federal funds rate will rise relatively slowly is conditional on inflation behaving according to the Federal Reserve’s forecast and remaining low. I do not think you can or you should take a statement about what the Federal Reserve expects that it will do if inflation remains low as a guide to what the Federal Reserve would do if inflation were to leap upward.

The issue of how much “hysteresis” there is in the economy–of how much damage to potential output growth has been done by the Lesser Depression–is a serious and important and terrifying one. But why should inflationary pressures be hard to contain? It is no longer the 1970s, and the Federal Reserve chair is no longer an Arthur Burns fearful that the Congress Will take his independence away if he raises interest rates too far too fast.

Over the past four quarters nominal Gross Domestic Product has risen at a rate of 2.9%/year and nominal Gross Domestic Income has risen at a rate of 2.6%/year. Over the past six months, real consumer spending has increased at a rate of only 0.7%/year. And over the past twelve months, real consumer spending has increased at a rate of only 1.9%/year. I am just not seeing this as any sign of an inordinate rate of increase in spending on currently-produced goods and services.

I look at this whole michegas, and I cannot but be bewildered at the origins, the strength, and the persistence of what I can only regard as an ordinary intellectual deformation. It astonishes, Confounds, and confuses me.

Oh well. At least I get to eat a free pizza dinner in a year. What wine should we bring in in a brown bag to drink at Zachary’s? And who else should we invite to share the pizza?

7472 words

July 28, 2014

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