Federal reserve implements its own stimulus

Great Debates
41

It’s occurred to me that maybe I haven’t made my point as clearly as I should have. So I’m going to try a different tack.

The reason that the market responds to fed actions and makes every effort to anticipate them is because they know how the process works. They know that putting $100B into the economy today will result in $200-300B in the economy a year from now as the direct result of the multiplier effect. THAT is what they are anticipating.

However the fact that Forex and other markets see this happening in no way affects the course of events. That $100B will still result in an additional $200-300B over the course of the year. If there is no need for that extra cash, then the result will be inflation. That is what markets are saying will happen.

Why do they think that when we already have $1 Trillion in excess reserves but no inflation? I don’t know but my guess is that they believe that the multiplier will gradually increase over that period of time. Right now it is about .9, but no one expects it to stay at that level forever. If it does in fact start to return to normal levels of between 2 and 3, then their bet is correct. In that case, $600B will result in an extra $1200 to $1800B in the economy and I don’t think anyone doubts the inflationary effect that would have (once the observed multiplier goes over a value of 1).

This type of change in the observed multiplier (or velocity) I believe is characteristic of nascent recoveries. A recession by definition means a slowdown in economic activity. Less activity means less demand for money. It also means that people don’t spend money as quickly. So the velocity declines. What I think is different about the Great Recession is the fact that it has declined so dramatically. Everybody understands this and everyone knows that eventually the multiplier will return to normal levels. In fact that trend is already underway and has been since earlier this year. We had a couple of slight bumps up in 2009, but basically it declined until February of this year. It began heading higher in March and while that trend has been interrupted a few times, it continues intact.

I believe that THIS is the overriding concern people have. They all know that we officially came out of the recession last September or thereabouts. They see the growth in the observed multiplier/velocity and know it is likely to continue.

So what happens if they are right? What does the fed need to do? It won’t be enough for it to simply drain the liquidity it has injected since at least part of that train will have left the station. IOW, some of that money will have already being spent and will have begat new money via the multiplier (which at that point will be > 1). What they have to do is CORRECTLY anticipate how the multiplier (a proxy for economic activity) is likely to change, how much new money is likely to be generated as a result, and THEN drain the correct amount. If they don’t drain enough, then you get too much money and hence, inflation. If you drain too much, you cut the legs out from under the recovery.

If you’re the fed, this means you can’t take a reactionary tack. You have to get the liquidity out of the system BEFORE it can do any damage. What’s more, you have a very narrow window regarding the correct amount to drain at any given point in time once you consider the multiplier effect and anticipated changes in the value of the multiplier.

42

This is exactly half wrong.

Now I’m not calling you stupid, and I’m certainly not saying you’re ignorant about banking. I’m talking about macroeconomic factors here, and banking is only part of that process. You’re pointing to half the jigsaw puzzle, and you’re acting like you have the whole picture. If you’re as versed in monetary theory as you claim, then a part of you should already realize what I’m saying here. You have the pieces, you’re just not using them. If you truly know monetary theory, and not just finance shorthand, then think back to the equation of exchange from quantity theory:

MV = PY

You say the money multiplier is the BASIS of monetary theory. Well, no. Or more precisely, it’s half the basis, because that equation isn’t a matter of debate. It is an identity, true by definition. Of course, it needs a theory to properly explain the relationships between the variables, but any possible theory you dream up can’t ignore velocity as “irrelevant”. Given an output level, if you want to claim that any increase in the money supply M increases the price level P, then you have to make the false assumption that velocity V is constant. That doesn’t work. Price increases are caused not just by the money multiplier, but also by changes in the velocity of money. I am not changing the subject when I point that out. I am completing the picture. When you focus exclusively on the money multiplier to explain price changes and economic output, while neglecting the velocity of money, you are misrepresenting monetary theory.

Constant velocity might be a useful shorthand in an undergrad classroom, but it’s not true in the real world. In certain situations, when the central bank lacks credibility in its base expansion, velocity can drop precisely because the base is increasing.

Emphasis added. If you have any other points you wish me to respond to, then please point them out. But I’m selecting this one sentence because it seems to be a core problem.

The money multiplier is, as you say, a proxy for economic activity. But there’s something you’re missing: By itself, it is an extremely bad proxy.

Of course, you already know there is not a single “money multiplier”. To get a particular multiplier, you must first define the broader money supply. And you’ve already demonstrated that you know how horrifically hard that is. This is what’s so puzzling about your posts. You’ve demonstrated genuine knowledge about banking, including the short-comings of the variables you’re using, and then for some reason you continue to rely on those unreliable variables. In turn, you accuse me of neglecting the multiplier. Not true. I’m not neglecting M. I’m simply adding V.

Look back at Measure for Measure’s post 23:

You talk about using the money multiplier as a proxy, and I have to ask: Which one? The whole reason there are so many definitions of the money supply is because all the definitions, and their related multipliers, are so unreliable. People’s changing preferences for liquidity lead them to rely on different kinds of money. You absolutely cannot rely on the money multiplier alone, or even all of them together, because the data is unclear. You need to complete the picture.

You’re been pointing out that the Fed doesn’t control the money multiplier. You are right. You’ve been pointing out a lag from the creation of the base to the appearance of the multiplier. You’re right again. (There’s an oddity here with bank regulation, but you have the textbook case right.) You’ve said that an increase in the multiplier (which will cause an increase in the broader money supply) can increase the price level. Bingo. You’re right yet again. And yet you still manage to neglect velocity.

M is important. Of course it is. But if M doubles and V halves, then your nominal income remains unchanged. More than that, though, V starts its effect right away, with no lag, and that’s true despite the fact that the export boost is based on higher expected inflation in the future.

You say the Fed can miss its timing with respect to the money withdrawal. Well, I wouldn’t say that the Fed is destined to hit 2% exactly. They can overshoot. If you want to get into political concerns, it’s possible that the rest of the FOMC could freak out, outvote Bernanke, and pull the hammer down in an excessively stupid way if they overshoot. But absent a major money shock, they’re not going to overshoot by much (in core inflation), because 1) there are already strong deflationary forces afoot in the form of idle resources pushing down prices, and 2) if they’re aiming at 2% and prices are rising faster than expected, they can announce a press conference and initiate a downward effect on V, immediately, based on changing future expectations. The drop in V will start to slow the increase in prices, even as the financial system money machine continues to create more M. Monetary policy is implemented with no lag, because monetary policy, properly defined, must include not only the money supply but also velocity reactions to credible future policy announcements. This no-lag credible expectation effect is not all of monetary policy, but I never said otherwise. All I said is that there’s no lag for implementation. You can only deny that if you restrict “implementation” of monetary policy to the money multiplier, which falsely cuts out another fundamental variable.

The process builds steam as the banks do their part with the money multiplier: lending the cash, having it come back, lending it again. But the velocity effect begins immediately, right after the chair gives a press conference with credible information about future central bank intentions.

43

Okay, I see one error I need to clarify.

I’ve been talking about “increasing” or “decreasing” V, but that’s not exactly how it works. Let’s say the central bank doubles M in a liquidity trap. Then you can expect V to drop in response. If V drops in half, then you’ve created no change at all in nominal GDP. This is, again, why I focus so much on expectations. If you double M in a liquidity trap, then V is going to drop by some amount. If it drops by only 49 percent, then you’ve just bumped nominal GDP. Some of that bump will result in higher prices, but in our present situation, roughly 60% or more of any nominal income bump will be a result of real output growth.

At first blush, there are all sorts of criticisms you might want to level against this. The Fed has no direct control over these either of these variables – M, as previously mentioned ad nauseum, is controlled by banks. But here’s the astonishing thing: the Fed does does have a surprising amount of control over future MV expectations. They can’t predict the exact money multiplier, and they can’t predict the exact velocity (especially since both velocity and the multiplier are calculated from our arbitrarily chosen definition of money). But they can predict, and to a large extent manage, both pieces put together. Why? Because that’s just another way of saying that they can have a measure of control over future nominal GDP.

We know that they have a real level of control here, because the markets respond immediately to their policy announcements. A change in future expected nominal income has immediate effect. And that immediate market response gets MV (not just V, as I falsely wrote, but both together) to begin rising immediately. Given the slack in the economy, the majority of that MV growth right now is going to be real output growth.

44

Well we seem to have drifted away from things that I’m confident of (ie we need more stimulus) to things for which I have opinions that are far shakier.

Velocity has never been constant. But for many years it grew at a fairly steady rate, at least for M1. In the mid 1980s, some diplomatic commentators posited that monetarism was made obsolete by banking deregulation, in particular the demise of Regulation Q. That’s a plausible story, but I prefer Goodhart.

Quite honestly though, I think of the Fed as basically setting the Fed Funds rate, and that’s it. That they do so via the purchase of Treasuries (and the release of high powered money) is something that is emphasized too much, IMHO. (I’m ignoring unconventional monetary policy,reserve requirement manipulation and of course regulation in this paragraph.)

  1. Friedman was a fine economist who got many things right and a few things wrong. Monetarism was one of his errors. His papers are a pleasure to read, if puzzling at times.

  2. I first encountered nominal GDP targetting in the Economist magazine: it was not presented as a form of monetarism. There are some who prefer inflation targetting, the argument being that it is very similar to nominal GDP targetting, but less likely to confuse the educated public. Capping economic growth may not play very well.

  3. Rules vs. discretion debate. Personally, I like a Taylor-rule approach.

Maybe. Is there really good evidence for this though? Krugman pushes this line, but I’m skeptical. Has a central bank ever succeeded in making a so-called credible commitment to anything and have the market fully believe them?* Maggie Thatcher and Volker both announced anti-inflation plans: if Rat-Ex was sufficient, we wouldn’t have needed a recession to break the back of inflation.

Stagflation occurs in the presence of a negative supply shock. In the 1970s, oil quadriplled in price in ~1974, then doubled in ~1979. Interestingly, the doubling was worse, because it was working off of a higher base.

Anyway, when inputs are more expensive, the economy must deliver some combination of higher inflation and lower output. In introductory terms, the aggregate supply curve has shifted backwards. Monetary and fiscal authorities, who can manipulate aggregate demand, can’t solve that problem.

The real failure of over-optimistic Keynesians was to put their trust in a fixed Philips Curve. Some economists thought that policy makers could choose a combination of inflation and unemployment from a curve. Friedman criticized this theory in the 1960s and blew the profession away when he was vindicated in the 1970s. Today, the concept of NAIRU -a non-accelerating rate of unemployment- is accepted.

Yes: NAIRU is basically the sum of structural plus frictional unemployment. Long periods of recession (and worker-friendly policies) therefore tend to drive it up. My answer: a) let’s talk when US unemployment hits 7%. b) I want higher inflation anyway – over the long run as well. 0.8% is too low. A higher inflation would both strengthen the effectiveness of monetary intervention and may even permit greater real wage adjustment, provided it stays below ~5%?? or thereabouts. (Cite: Akerlof & ??, which I need to review)

To sort this out, I would need to show a case of falling unemployment and falling inflation. I can do that: the example is the US during 2010. To my way of thinking, inflation falls when unemployment is far above NAIRU (assuming no supply shocks or currency collapses).

  • The market does watch the Fed carefully of course. This change in Fed policy was telegraphed to the market over the past 2 months: long and middle term rates dropped accordingly. Indeed, the market over-estimated the ambition of the initial announcement: long rates snapped back up a bit.
45

Life is complicated when you’re a monetarist. Luckily, the Fed is staffed by eclectic pragmatists. When unemployment hits 7% or so, the Fed will think about raising the Fed funds rate – one quarter percent at a time. If inflation accelerates, they will move faster. If they truly think they need to sop up extra liquidity, they can raise reserve requirements.

Ok, but QE1 provides evidence against this POV. The Fed flooded the system with liquidity and no inflation (or hyperinflation!) ensued. Now frankly, that didn’t surprise many informed observers. What was interesting was that aggressive monetary easing didn’t prevent the financial system from seizing up. Milton Friedman in his Monetary History of the US blamed the Fed for the banking crisis of 1930-33: though the Fed loosened a lot, they didn’t do so as much as Friedman would have liked. But now that we have a 2nd example, we know that loose monetary policy is not sufficient: the financial system won’t automatically fix itself under such circumstances. There were a number of hypotheses about the Great Contraction of 1930-33 that were resolved in 2007-2009. Milton Friedman didn’t look too well, but neither did those who focused on aggregate demand. Instead Ben Bernanke of all people was vindicated: the collapse of financial institutions truly does have consequences that are not easily patched with monetary or fiscal fixes.

46

So do a lot of other folks, when the Taylor rule isn’t suggesting an impossible negative 5 percent fed funds rate, as is the case now.

NGDP targeting has no such problem.

Yes. Here’s the Great Depression. Here’s recent Japan. Here’s the current situation.

The most impressive of those graphs is the one from the Depression. Notice the immediate relationship, no lag, between industrial output and real wages (that leaves out the causal factor, but it’s still a beautiful picture). The second shows Japan’s decision to accept near-zero NGDP growth. They didn’t have to do this. They had a brief flirtation with QE, but then the BoJ deliberately raised interest rates again, more than once, to cut off any positive inflation rate when it was approaching zero from negative numbers. The third graph is from Krugman, and I want to slightly modify what you said because he actually disagrees with MV targeting, as he explains in that post. His position is subtly different, and this was frustrating as hell because for the longest time, he never explained why he disagreed. It took him a full year to finally explain his model, which he did only recently.

It’s a shitty explanation, so here’s Worthwhile Canadian Economist Nick Rowe translating the model into simpler terms. Krugman believes that deflationary pressures are so strong that inflation will not rise, at all, unless the central bank aims for an inflation rate of 4 or 5%. Basically, he argues that 2% inflation is an unstable equilibrium, and thus unsustainable. Inflation might creep up for a bit, only to come crashing down again. Personally, I think this is horseshit, and I think the fact that Krugman is so inept in his argument is part of the long-term rhetorical point in his post.

He knows a more stimulative policy would work better, so in his models, he presses a balls-to-the-wall monetary solution, on the possibility that there’s no equilibrium at 2%. I mean, that’s theoretically possible, but the markets are screaming at him that he’s wrong. I don’t exactly believe in the EMH, but I do believe that the markets deserve the benefit of the doubt unless you can provide more evidence why they’re wrong. He doesn’t. Why is there a higher equilibrium at 4%, and not 3%? Where does he pull that four from? Why not 2.5%? Why not 2.25%? He never gets into that, and I think it’s precisely because he knows his argument is weak. Not that he’s lying. He does have a semi-plausible mechanism. But it’s rhetorical slight-of-hand, and that’s why I don’t believe him on this one.

I have similar criticisms of DeLong. DeLong points out, rightly, that we don’t know how much money it will take. But that’s the whole point of a long term level target, which is a self correcting monetary rule. This is something that is simply impossible with fiscal spending. If you’re using a reliable money rule, instead of discretion, that means your rule automatically changes to compensate when you miss the first time, so you can quickly figure out how much money you need.

Yes. Exactly.

47

I have another question:

Let’s say that invcreasing M tends to decrease V, but maybe not in direct proportion. So the money supply shrinks becaue of falling V, so you increase M through QE. This causes a further fall of V, but the money supply does expand somewhat. So you add more money.

Eventually, you manage to reinflate the money supply, but youv’e done so with a huge quantity of money being moved very slowly.

What does that do to stability? It seems to me that you’ve set up a situation where very small changes in velocity now result in large swings in the aggregate money supply. Is this not the case? Is there not a risk here of the money supply increasing faster than the Fed can control if velocity starts to really ramp up?

48

One other point I want to make: Even if Krugman is right that a 2% inflation target isn’t enough, he would have to agree with me that a 2% long term price level target would eventually work, even though he believes the higher inflation equilibrium is at 4%.

Let’s say the Fed institutes a 2% price level target. So the target should be 2% next year. But inflation is only one percent. That means the next time that the Fed has to overcompensate for missing its first target. The long term target is two points every year: 2+2=4. But the actual result was one point the first year. That means the target for year two is three percent: 1+3=4, in order to get back on the long term path of price level increases. But if that still doesn’t work? Then it compensates again. The long term target is 2+2+2=6. So if we undershoot for two years running, that means another automatic recalibration: 1+1+4=6. Voila! Krugman gets his 4% equilibrium, even though the Fed is only shooting for 2% price growth every year.

What just kills me is that Bernanke knows this. I haven’t written a single thing that he doesn’t already know about. This is Ben Bernanke’s idea. This was, in fact, his very suggestion to the Japanese, and yet the Fed still, to this day, hasn’t instituted a long term level target. I can only assume that he is surrounded by well-intentioned financiers who don’t know macro.

This basically returns to the question about the short- vs long-run Phillips Curve. I’m saying that the short run curve will hold for a while.

In other words, the majority of the NGDP growth will be seen in real output, not price increases. Why? By the previous mechanism I explained: The thing that causes prices to increase is too many dollars chasing too few goods… but right now, we have a general glut. The first thing those dollars are going to do is buy up all that idle capacity. Then you’ll have price increases. Y will rise more than P does. And that will be seen and noted by the Fed. When we get closer to the NAIRU, the Fed will start sucking those dollars out of the system again. They can’t control the banks directly, but given the deflationary buffer, they will be able to keep MV from rising too quickly when the growth in Y has been tapped. The markets aren’t always right, but they bear me out on this so far. And I do trust the markets, unless I have a convincing reason not to.

That is especially true if the markets have a clear target. And they do. The Fed has (implicitly) targeted a 2% inflation rate for twenty or so years. They dropped the ball in the Great Recession, but now with QE2, everyone is expecting the Fed to go back to their old target of 2% and then stop. (A better target would be MV, not P, but we can’t get everything.)

If the old data is unconvincing, then you can test what I’m saying in the next year. Watch what happens with GDP (both real and nominal). The majority of the nominal rise will result from real output growth. Watch Great Britain, too, which is going full tilt based on what I’m saying. They’re instituting a contractionary fiscal policy and compensating for that with a quasi-monetarist expansion of MV. This is a firm belief by the current British government in the superiority of new money over government spending. That’s quite impressive confidence in what I’m saying here. And you know what? It’s a bit early to say, of course, but right now first indications make it seem like they’re going to pull it off. Maybe that’s the test you’re looking for.

49

Here’s where I have a problem: Yes, there is a general glut. But I have a problem with treating the economy in aggregate terms like this. There are plenty of industries or job specialties that are at full employment or close to it, and plenty of goods for which there is not particularly excess inventory.

So while the idle resources do not increase in price, the stuff that’s already clearing the market will will see inflationary prices. Energy, imports, food… These products and millions of others will see their prices change out of proportion to others. But it won’t be because of a real change in relative demand, it will be because of monetary policy.

How can this not create misallocations? The part that I think economists who work in aggregates forget (or downplay) is the fact that the real economy consists of complex, interwoven connections of supply chains, factories and assembly lines, long-term projects and short-term projects, research programs, producers and consumers. Real destruction of wealth occurs because of these manipulations. Companies over-invest or under-invest. Low interest rates bias for capital-intensive, long term investments. If all those signals are false or temperary because the Fed manipulated the money supply to create them, wealth will be lost when reality reasserts itself.

Just think what we could have done with the hundreds of billions of extra dollars that flowed into the real estate bubble. Think of the other things that could have been built by the labor of the people who built houses that are now abandoned. If the fed had not held interest rates artificially low, and if the Chinese government had not intentionally manipulated the savings rate and flooded the west with dollars, our economies would have operated much more efficiently. We would be wealthier today.

On the other hand, wealth can also be destroyed when changes to the money supply happen for other reasons. or when external shocks are applied. I understand and agree with the need for the fed to attempt to stabilize the money supply. Ultimately, if the fed can maintain a slightly positive inflation rate, that would be a good thing.

But I just believe that economists are underweighting the potential for real harm to the economy by constantly manipulating macro measures. Paul Krugman in particular seems to see himself as the man behind the curtain, tugging and pushing the levers of the economy to make it do exactly what he wants it to do. He thinks it’s a machine to be tuned by clever economists. He has no intuition for the sheer complexity of the mechanism and its sensitivity to being manipulated.

50

Yes, there are. And I went through that in more depth in your own Austrian thread. Maybe that was more in response to other posters than to you.

Anyway, the process doesn’t need all industries to have slack. That some industries are more cyclical than others contributes to the problem. That is to say, some prices are sticky, and some are flexible. The result is that the people who manage to stay employed maintain strong real wages. Their sticky purchasing power does fine, even as others are thrown out of work. There’s a certain irony here, in that it’s the markets that respond more slowly to recession that benefit the people who stay employed. The sticky wage people who keep their jobs do the best in this sort of recession. But thankfully, that helps in the other direction, during recovery. Who’s going to benefit from the return of money movement? The flexible wage folks. Why? Because their industries are flexible and respond more strongly to cyclical effects. The very forces that keep the standard “recession-resistant” industries doing alright in the downturn are the same forces that keep their prices relatively stuck even when recovery happens.

The very stickiness that causes the relative price distortions during a huge adverse AD shock also mitigates the inflationary impact of recovery. It’s sticky down, and still mostly sticky back up. As long as it’s the fluid price industries that soak up the first bit of money movement – and they will, precisely because theirs are the fluid industries – the increase in inflation will remain subdued. This is the process of people getting back to work.

That is the mechanism. That is what pushes new money toward more output, instead of just to higher prices.

When enough people are back to work – when unemployment is 7% or so, getting closer to the NAIRU – the lack of such a big glut in fluid price resources is going to start to lead to genuine upward pressure on all prices. But that is exactly when it’s time to reverse course with monetary policy.

The misallocations already exist.

They are all around the US.

Near 10% unemployment and even higher underemployment is a huge, costly misallocation. We won’t get back down to 4.5% anytime soon, but strongly easing the current misallocation is worlds better than doing nothing. More money that’s moving faster will reduce the problems of misallocation, not increase them, by removing the relative price distortions. Getting prices back to levels that better reflect relative preferences is the solution to the problem. Not to mention that the other standard criticisms of fiscal spending don’t apply. You can’t blame poor choice in government spending projects as an additional distortion. The increase in output will be the result of free market decisions, not political boondoggles: no GDP festishization from government spending here. Nor can you blame future debt concerns. There’s no borrowing going on here, and so no crowding out effect to finance interest. Deficits will actually go down instead.

This approach considers market reactions. This is not to deny that the market screws up sometimes. But the whole point of what I’m saying is to give the market the benefit of the doubt, after the psychologically-based sticky price problem is taken into account. A libertarian should be comfortable with that. That’s why so much of what I’m saying stems in way or another from Old Man Milt.

Okay, first, I have no patience for blaming the Chinese, just as I will have no patience if other countries blame us for what we’re doing now. It wasn’t their fault. They had a part to play, yes, but it was nevertheless our own irresponsibility that was at fault. I don’t cotton to blaming others when the primary bad decisions were all our own. Maybe you didn’t mean it that way, but I want to be clear on this point.

And next: You can’t blame the downturn on housing. Some? Sure. But the majority of the problem was the AD shock. There was a housing correction that started in 2006. Yes. It was a mite painful, and unemployment started to increase. But then, quite suddenly in late 2008, NGDP dropped at the fastest rate since the Depression, corresponding in no coincidence at all to the biggest recession since the Depression. The housing problem is structural. Correction is unavoidable. But the next step was indeed an avoidable AD shock that was allowed to happen because of tight money: “tight” defined as insufficient to maintain stable future NGDP expectations.

There will be structural problems in the future. Sure. Sometimes the market makes mistakes. But those problems will be easier to deal with if don’t compound them with other mistakes. We should maintain a stable monetary policy in order to accomplish that.

You probably already know that I don’t always agree with him. But despite whatever disagreeable personality traits he has (many of which I happily share), he is not to be underestimated.

He is right (about economics) an astounding amount of the time. In my opinion, this is because he gives markets the benefit of a doubt. I’ve read his popular writings for a long time now, and despite his rhetorical suggestions to the contrary, he really only naysays the markets when he has real evidence that they’re wrong, like the housing bubble. I am convinced that that is one of his real strengths. It’s been my own catchphrase for a while: markets are not always right, but they do deserve the benefit of the doubt.

And I think that’s enough going in circles from me. I’m on the record with both explanations of the process, not just here but in past threads, as well as clear predictions about what will happen if MV finally starts to work its way up. The differences between the US limited QE, the stronger British money response, and the EU response to the PIIGS problem (Ireland next) will be available for everyone to see soon enough. I’m not going to quote equations from the better formal models, so there’s not really anywhere else I see to go.

For me, it’s all been said.

51

Big Policy Picture: We’re in a deep recession, which is bad. Inflation is low and falling, which makes things worse. Under conditions of deflation, real interest rates necessarily become positive and conventional monetary policy becomes ineffective. Fiscal policy retains its effectiveness but we’ve learned since 2007 that it’s hard to implement at sufficient strength for political reasons.

Let me be clear: I used to think that another great depression was impossible, because the public wouldn’t put up with it and Congress would just love having an excuse to spend lots of money and cut taxes. I was wrong: it turns out that a) the minority party has every incentive to gut economic recovery and b) Congress has a politically optimal deficit: it’s hard to go a lot above or below that. So while I have in the past ruled out another Great Depression on this board, I can no longer do so. I still believe it to be unlikely. In contrast a lost decade seems mildly probable, alas.

Metaphorically, when the car is heading towards the embankment, you don’t worry about the fact that you haven’t changed the oil in two years. You pump the brakes and try to steer the car away from its catastrophic path.

Technical chatting:
Hellestal: We should discuss expectations at some point. But first let me relate some skepticism about the monetarist model.

MV = PQ

In the above equation, there are direct measurements for M, P and PQ. Q is almost measured directly, but V is certainly not: V is merely a ratio:

V = PQ/M.

Now in a pure cash economy, V has a lot of intuition: it’s the number of times a dollar’s worth of currency is used to purchase goods in a given period of time: “Currency turnover” might be a decent description. When M includes zero-interest checking accounts, a similar logic might hold. But while the preferred measure used to be M1, it is now M2, which includes money market funds, savings accounts and even CDs that are under $100,000(??). That is, it includes a lot that is generally considered wealth. M2 is best conceived as an equilibrium between monetary demand and money supply – the money supply coming from high-powered money provided by the Fed during open market operations. But flows between M2 and the part of M3 that is not in M2 are affected by considerations outside of the purview of the central bank. So it’s not surprising that the relationship between M2 and the economy would be noisy – V is a ratio that we shouldn’t believe to be especially stable.

In fact, before I visited the Fed’s website the other day, I had no idea what the M2 path looked like. [1] But I did know that the relationship between M2 and the economy was a noisy one, I knew that unemployment was way above NAIRU, inflation was falling and the monetary base had exploded. Given all these shocks, I was expecting a screwy chart and… well, there it was.

M2 is a sideshow. Focus on interest rates, prices and output.
[1] …unless it showed up in one of Krugman’s blog entries that I remembered semi-consciously. I certainly didn’t know about the M1 chart though.

52

There are no reliable direct measurements for M, any more than there are for V. Velocity is a ratio, sure, but it’s a ratio determined by an arbitrary and unreliable choice of M.

The real value of “M”, abstractly, can’t be pinned down by just relying on any given “direct” measurement. The direct measures don’t actually measure anything reliable in the short term. That was the whole classical monetarist problem. Rather, “money” is based on our own personal psychological beliefs in how much direct liquidity we have access to. In times of economic expansion, we’re likely to think of our money in terms of the higher level Ms: M2, M3, shadow money, and whatever other moneys are created by financial manipulations, which we believe we have access to when needed. The measurement problem for V is due to this unreliability of M.

But MV can be measured. It is nominal GDP. If it increases, it means that the total face value of dollars that change hands over the course of the year is increasing, no matter how those dollars are defined. Increasing MV expectations is the same as saying: There are going to be more effective dollars bouncing around this year than last year. So hey, economy, do you want to get in on that action?

There has been too much focus on interest rates since the fed funds rate went to zero.

People say, hey, interest rates are zero! That means money must be easy! No. Money is tight: The Taylor Rule is giving a suggestion of negative five percent. We’re way higher than where we should be, and that’s precisely because NGDP was allowed to fall. It should never fall.

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I don’t see a lot disagreement on the monetarist front. I’ll note though that the whole theory was a lot more intuitive when money was a worse store of value (because it didn’t pay interest) but a superior transactions vehicle (because you couldn’t write a check off of an interest bearing account, ATM cards didn’t exist and credit cards either were nonexistent or had just been introduced).

Yes, money is tight: the interest rate approach suggests that we need additional stimulus. In this light QE2 is an attempt to flatten the yield curve: my understanding is that the economy responds more robustly to falls in longer duration interest rates than it does to falls in, say, overnight rates. QE2 might be seen as cutting the 5 year rate by 3/4 of a percent, IIRCandMaybeIdont. This is weak, but still appreciated.

Ok, now we’re at the crux of a less important disagreement, or rather a divergence in perceptions. Setting aside public diplomacy, I actually support targeting nominal GDP at, say, 6-7%. Of course, given the lags in GDP reporting of both preliminary and final estimates, intermediate targets would be necessary as well. But that’s a technical matter. (Conveniently, M is available within about 2 weeks and presumably V can be forecast. This is where the MV=PQ equation might be of some use, at least within the halls of the central bank.)

But you seem to put more faith in Fed announcements. Let’s say the Fed announces an inflation target of 5% per year over the next 5 years. Why would potential purchasers of capital equipment believe them if we are in a liquidity trap? Moreover, why wouldn’t the bond market just juice long term rates up to around 7%? It seems that this proposal (by Krugman, though I may have a few details off) turns on a gullible Main St and a naive Wall St (or visa versa?). If anything, I would think the reverse would be true. But to a first approximation, I would think that they would both be in sync.

The answer might be to combine a targeting with unconventional monetary policy: make a commitment to higher prices and sufficient long term bond purchases. Maybe this obvious, but I haven’t seen it discussed. And I’m not sure it would work.

UK: They’re in better shape. Their short term interest rates are at 0.8%, so they can be cut a little more. Moreover, their inflation is at 3.1%, so they can achieve nontrivial negative real rates.

Now that I have all that out of the way, what do you mean by “Allowed to fall”? We had a financial crisis: both prices and output were going to collapse. I’m not trying to play word games here: rather, I’m having trouble with the idea that the Fed manipulates expectations and economic behavior all that well via its announcements and public stances. I recognize that these sorts of assumptions are standard in macro, but at least part of that is for convenience.

I believed that 4 years ago. I believed that 20 years ago. I am more skeptical now.

Emphasis in original dutifully copied. This is not the behavior of an institution that deserves the benefit of the doubt. No, the revealed opinions of financial markets deserve heed, but also scrutiny.

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I put faith into credible long term targeting mechanisms, which are self-regulating. Credibility can be further supplemented by information from an NGDP futures market, if they ever get around to making one.

They have tools to increase their credibility. This is another topic I spent some time explaining in Sam’s Austrian thread. But I am loathe to go in circles.

You’ve got the causation reversed.

If the target is 5% inflation, and (real) yields on long term bonds rise to levels consistent with previous periods of economic recovery, then this is what we call success. Expectations of economic recovery => Higher yields. Again, it’s a mistake to focus so much on interest rates in our current situtation – or at least, to focus on them as an overriding causal factor. Long-term yields largely follow the macro situation, they don’t lead it.

I don’t disagree, exactly, but this gets into the nature of these markets and how “efficient” they are.

My criticism of the EMH would take a freakin book. Or at least a couple chapters. But to make it short: the EMH is wrong, but it’s not wrong in the way that people typically think of it as wrong. New information is, in fact, incorporated. If that weren’t true, then investors would be able to consistently beat index funds. They don’t. They never do. Never, ever, ever. There are market errors, yes, but errors are the result of entrenched bias. That bias doesn’t last forever, and so the profit ability to take advantage of that bias is very limited. With the housing bubble, anyone with two brain cells to rub together was able to point out the entrenched bias. It was freakin obvious. But now? The process begins again. The info is reincorporated. That old bias has been corrected, and if you have a new issue with the market as it stands, you need to point, again, to fundamental factual reasons for your issue. And the evidence, again, needs to be as overwhelming as it was in the housing build-up.

Markets aren’t always right. But they do, eventually, correct themselves. The best thing that the Fed can do is to make its policy credible, so that we get a credible response from the markets.

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Ref:
Sam’s Austrian Thread: The Case for Austrian Economics - Great Debates - Straight Dope Message Board
Hellestal’s We Need More Monetary Stimulus Thread: We need more monetary stimulus, and we need it now. - Great Debates - Straight Dope Message Board

Generally speaking, I’m in favor of throwing everything at the problem in order to prevent deflation. And in practice, I would favor explicitly higher inflation targeting – since it seems to me that the 2.5% long run target (source: Livingston Survey) was too low. We shouldn’t even have deflation scares. Still, you can’t put a lot of confidence in ideas that haven’t really been tried yet.

h/t Scott Summers via Hellestal:
Then again this idea seems plausible. Put a tax (oh sorry, a charge) on excess reserves. That looks a lot like a negative nominal interest rate to me, which is what we need but what I had thought was not possible. That could be a real paradigm shifter: suddenly monetary policy regains some traction. Heck the Fed could pay interest on required reserves and charge a fee for excess reserves if they didn’t want to slaughter the banks’ balance sheets. Essentially, this forces a decline in lending standards (at the margin) which is what we need at the moment. But it’s reversible. (Alternatively, it would encourage a further decline in mortgage rates, prime rate, etc.)
TheMoneyIllusion » FAQs
Ah but excess reserves are a small part of the economy, right? [Clouseau]Not anymoor.[/Clouseau] Unintended consequences include purchases of junk bonds and other dubious assets. But hey, the banks are regulated. Worth a try.

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Hellestal, let’s say that QE can do the job of getting the economy going again. Krugman and others are saying that the amount of QE should be much higher than it actually is. Do you think a trillion dollars of QE2 is going to be enough?

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QE2 should have some positive effect, but it certainly doesn’t seem near enough (for instance, the yield for 5-year TIPS is still negative).

So yeah, I remain in agreement with K-Thug et al on most of the particulars.

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I just can’t understand why the bond vigilantes keep lending the government money at negative real rates of interest.

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Like I said, I’ve learned a lot about economics in the past 3 1/2 years: times have been interesting. I used to think that standard macroeconomic textbooks represented the consensus of the economics profession. I used to think that real business cycle theorists did interesting work, insofar as perhaps some aspects of their models could be folded into a wider framework. After all, the economy has both a supply side and a demand side, and the former might have some stochastic aspects not picked up from aggregate measures of education, infrastructure, capital investment and R&D.

I misconceived. John H. Cochrane and Eugene Fama of the University of Chicago are hard thinkers and talented financial economists. But they both posted arguments on their blogs that seemed to indicate that they were unaware or had forgotten material taught to every sophomore major in economics. Don’t get me wrong: there are not and should not be any unassailable doctrines in academia. I’m not objecting to heresy: I’m making claims about obliviousness, ignorance and frankly embarrassing behavior. Links to the sordid business here. Wiki article on crowding out here: note that it applies mostly in times of full employment: during recession, higher government spending can add to income, since the economy has excess capacity. Now it’s ok to disagree with that: my problem is with an evident lack of awareness of this standard college-level concept.

Anyway, there are plenty of liquidationists who agree with Sam’s earlier posts in this thread. A bunch of them just wrote a public letter to Ben Bernanke. Now a few are just hacks with lousy track records like William Kristol. But others are bona fide economists. I have no idea what their underlying model is. Perhaps they could share it with us.

Anyway, I should lay down some markers. In the absence of a negative supply shock or a sharp decline in the dollar, I maintain that unemployment above 9% should lead to further declines in core inflation. In 2011. Furthermore, any sort of decline in the dollar that happens in 2011, should be beneficial for employment prospects in 2012. In the absence of a supply shock, higher inflation should reduce unemployment. *

It is difficult to predict whether the US will receive beneficial developments such as renewed fiscal stimulus or an export-enhancing decline in the dollar. But I think I can go on record with the sort of relationships that we would expect to see. And I would be willing to lay odds against US hyperinflation in 2011-12. Inflation will not exceed 30%, never mind 100% or 1000%. (Why oh why doesn’t Intrade create a betting market in hyperinflation?)

  • If we weren’t in a liquidity trap, my take would be rather different.
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These guys are the leading current figures on the Chicago school of economists and the wider subsection who belive in the perfect market hypothesis. Obviously the events of the last couple of years have taken a bit of a wrecking ball to their ideology, or at least you’d think so, but well after the meltdown they were still trying to explain the meltdown wasn’t inconsistent with perfect markets. That led to one of them, can’t remember which one, claiming that the market meltdown occured because George Bush went on TV and said there was a serious problem with the financial markets and they’d need government help.

As far as predictions about the economy go, here’s mine. We’re going to have a lost decade (at least). Rubbish growth levels and periods of zero growth and recession and the benefits of what growth we do get going overwhelmingly to the top 1% of earners. Despite it becoming increasingly obvious that the distribution of wealth is increasingly scewed towards top earners and their increasing share of income is preventing broad-based economic recovery, governments of all stripes will do nothing to substantially affect this.