Uneasy Money

Stephen Williamson weighed in recently on Keynesian Economics versus Regular Economics in his New Monetarist Economics blog.  Responding to Paul Krugman’s post citing my criticism of Robert Barro’s column in the Wall Street Journal contrasting Keynesian economics and regular economics, Williamson took Krugman to task for not acknowledging that old-style Keynesian economics has actually been replaced by a newer version (New Keynesian economics) that actually tries to deduce standard Keynesian results from regular economics.

Although Williamson aimed his criticism at Krugman, not me, he did criticize this passage of Krugman’s blog in which I was mentioned

As Glasner says, there’s something deeply weird about asking “where’s the market failure?” in the face of massive unemployment, huge unused capacity, an economy producing less than it did and a half years ago despite population growth and advancing technology. Of course there’s some kind of market failure, which means that there’s nothing at all odd about asserting that better policy can yield free lunches.

Williamson comments:

We cannot observe a market failure. To deduce that a market failure exists, one needs a model. Given that we cannot observe market failure by looking at the state of the economy, we also can’t say what a “better policy” is. Again, for that we need a model.

Fair enough; we do need a model.  But it is not clear what kind of model Williamson thinks is needed to infer the existence of a market failure.  The standard model used in regular economics posits a process of price adjustment in which unsatisfied demanders bid up the price or frustrated suppliers drive it down until a price is established that clears the market, i.e., transactors can execute their offers to buy or sell as planned.  In recessions and depressions, as opposed to “normal” periods, the standard model of price adjustment doesn’t seem to work.  So there seems to be a prima facie case for saying that recessions and depressions involve some sort of market failure.  The case may be rebuttable, but Williamson seems to acknowledge in responding to a comment 0n a subsequent post that at least one rationalization for cyclical unemployment is unacceptably implausible.

In the later post Williamson sends us to an essay published by the Richmond Fed in which Kartik B. Athreya and Renee Courtois argue that the first theorem of welfare economics teaches us that to justify intervention into the private market economy, it is necessary to establish that the array of existing markets is incomplete or not fully competitive.  This is a remarkable assertion inasmuch as I am unaware that anyone ever asserted that the set of markets in existence is anywhere near the set required to satisfy the completeness conditions of the first theorem of welfare economics.  (But maybe I am ill-informed).  So what exactly must be shown to establish what is self-evidently true:  that the necessary conditions specified by the first theorem of welfare economics do not obtain in the real world?

Here is how Athreya and Courtois characterize the practical implication of the first theorem of welfare economics for macroeconomic policy. 

The preceding result implies that in a well-functioning market system [i.e., a perfectly competitive economy with a complete set of markets, a theoretical requirement with no real-world analogue], the adjustments made by individual and firms in response to a shock in fundamentals, even when they are contractionary, will be efficient.  If something bad has happened to the ability of firms to produce output (say, a shock to the financial sector that hinders the allocation of labor and capital to their best uses), then each hour of labor becomes less productive.  In this case, it make little sense for firms to continue producing, or for workers to work, at previous levels.  After a storm, for example, a fisherman may find that each hour spent in the boat produces less fish; an efficient response is for him to spend less time fishing (hire less labor) and more  hours consuming leisure (or, perhaps working on boat maintenance and repair), given that the cost of leisure or other activities, measure in terms of fish foregone, has fallen.

This example is meant to show that even if there is a shock causing a decline in output and employment, it does not follow that the adjustment – reduced output and employment — to the shock was inefficient.  This is a basic proposition of real-business-cycle theory, regarded by some as quintessential regular economics.  Negative productivity shocks imply reduced output and employment, so who is to say that observed output and employment reductions in business-cycle downturns are not characteristic of an optimal adjustment path?

Athreya and Courtois acknowledge that “frictions” can cause responses to a negative productivity shock to be inefficient, e.g., frictions in capital and labor markets, and in insurance markets.  But in discussing inefficiencies in capital markets, they merely refer to banks’ difficulties in discovering good investment projects.  Their discussion of labor-market inefficiencies is no more helpful, referring to problems of matching workers and employers, which can cause the search process to be long and drawn out.  But just because matching workers and employers is costly and time-consuming doesn’t tell us how much search is optimal or whether the actual amount of search in response to a recessionary shock is optimal. 

They do provide a somewhat more helpful discussion about the process of reducing labor input, suggesting that there is an inefficiency in laying off workers rather than evenly reducing hours across the entire work force.  But this too is problematic, because, as they acknowledge, there are various reasons why letting some workers go and keeping the rest fully employed rather than cutting hours is less costly for employers than trying to reduce hours worked equally across their employees.  The hardship is concentrated on a subset of workers rather than shared by all workers.  But is there an inefficiency?  We aren’t given a model from which to draw an inference. 

Finally, there is the absence of a private market for unemployment insurance.  In the absence of such a market, and because most of the reduction in labor hours is concentrated on a subset of workers, workers respond to the increased probability of losing their jobs by increasing precautionary saving.  Athreya and Courtois admit that they cannot demonstrate any inefficiency in the increase in precautionary saving except insofar as it is related to frictions  in labor and insurance markets, but they provide no proof of such inefficiencies, leaving the impression that the inefficiencies are not that significant.  That impression is reinforced by the following remark.

The preceding suggests there may be a role for policy.  However, it also suggests that productive policies will likely be those which directly address the specific frictions in capital, labor, and insurance markets that make the observed decline in aggregate consumption inefficiently large.

We are not told exactly what the specific inefficiencies are, but, presumably, if we can find them, then it’s fine to do something about them.  But there is little if any justification for trying to increase aggregate demand through fiscal (or monetary?) policy.

[C]urrent spending-based stimulus, while it may marginally increase the probability of a laid-off worker regaining employment, will also likely draw employed workers away from other productive uses – further hindering efficient resource allocation.

Their most explicit recommendation is actually somewhat surprising (what would Robert Barro say?): 

We think a more fruitful approach would be to leverage the existing unemployment insurance and social safety net infrastructure to better insure the unemployed while more strictly monitoring their job search efforts.

What amazes me about the real-business-cycle approach exemplified by this paper, apparently much to Williamson’s liking, is that it ignores any transmission mechanism amplifying a shock as its effects spread through the economy.  Such transmission effects are completely suppressed in the representative-agent model, a characteristic real-business model seeking to deduce all the relevant properties of a business cycle from the analysis of a single agent supposedly representing everything that one needs to know about how an economy behaves.  This is not just a retrogression from Keynesian economics, it is a retrogression from pre-Keynesian classical and neo-classical economics. 

Despite Keynes’s misguided attack on Say’s Law, the notion that supply creates its own demand, an idea Keynes misconstrued to mean that classical economics held that there could be no lapses from full employment, or if there were, that they would be temporary and quickly rectified, Say’s Law actually explains precisely how shocks are transmitted and amplified as they spread through an economy.  If supply creates its own demand, then a failure to supply entails a failure of demand.  So a technology shock that causes some workers to lose their jobs, by preventing them and complementary factors of production from supplying their productive services, necessarily forces those workers, as well as owners of complementary factors unable to supply their services, to reduce their demands for products.  That is precisely the idea of the Keynesian multiplier, except that Say’s Law views it from the supply side and the multiplier views it from the demand side.  At bottom, these two supposedly contradictory ideas correspond to the same phenomenon, viewed from opposite angles.  But the phenomenon is completely suppressed in the representative-agent model.

But where is there any inefficiency?  Well, as we have just seen, it is really — I mean really – hard to find an inefficiency if you try to understand what happens in a recession in terms of a representative-agent model.  In a representative-agent model, the entire analysis collapses to finding the equilibrium of the single representative agent.  You have necessarily assumed that social and private costs are equal, because you have collapsed all of society into the representative agent.  Private and social costs are not only equal they are identical, because that is how you set up your model.   You have taken regular economics to its outer limit, and you have annihilated the multiplier.  Good job!

But if you think of economics as the study of interactions between independent decision-makers rather than the study of a single decision-maker in isolation, and if you recognize that production and exchange between individuals may not just transmit, but amplify, disturbances across individuals, you may prefer to think of an economy as a network of mutually interdependent transactors whose decisions about how much to supply and demand reverberate back and forth across the network.  Because it is so highly interconnected, private and social costs in the network need not be equal; indeed externalities are a characteristic feature of networks.  The pervasiveness of externalities is well understood in payments networks in which the insolvency of a systemically important transactor can cause the entire network to collapse.  The looser interconnections of the real economic network of production and exchange is less brittle than a specialized payments network, but that doesn’t mean that the former network is not also pervaded with externalities, a point beautifully articulated by the eminent Cambridge economist Frederick Lavington when, when referring to an economy at the bottom of a recession, he wrote in his book The Trade Cycle, “the inactivity of all is the cause of the inactivity of each.”

So is there any inefficiency in a recession?  Of course.  And is there an economic model that identifies the inefficiency?  Absolutely.

I was hoping to take it easy today and prepare for Hurricane Irene as it makes its way toward the East Coast, but Alan Reynolds, a very good economist (UCLA undergrad) whom I have known and liked for a long time, got in the way.  Alan somehow has gotten the idea that monetary policy cannot stimulate a recovery, thus adopting the doctrine that kept the US from recovering from the Great Depression for over three years until FDR courageously devalued the dollar and took US off the gold standard.  I thought that Alan understood this, especially because he read the manuscript of my book Free Banking and Monetary Reform as I was writing it, and seemed to have understood and accepted the argument I made about the monetary (i.e., the gold standard) cause and the monetary cure of the Great Depression.  Alas, either I did not succeed as well in enlightening him as I had thought, or he subsequently reverted to some old mistakes, our interactions having become increasingly less frequent.  So I take no pleasure in criticizing Alan, but, hey, a blogger’s gotta do what a blogger’s gotta do.

Alan, the creme de la creme of contributors to The Wall Street Journal editorial page, wrote an op-ed today accusing the Fed of having slowed down the recovery by adopting its program of monetary easing (QE2) last fall.  This is a remarkable and, on its face, counter-intuitive claim.  Nor does Alan provide much in the way of a theoretical explanation for why monetary expansion would would have slowed this recovery down, in contrast to other recoveries in which it hastened recovery, he suggests that by causing the dollar to depreciate, monetary expansion fueled a commodity price boom, thereby driving up costs and reducing the profitability of US businesses.

I don’t think that is a very plausible theoretical argument about how QE2 affected the economy.  On the other hand, even Ben Bernanke has been unable to give a proper explanation for how monetary expansion would cause an economic recovery.  Bernanke argues that monetary expansion reduces interest rates, already close to zero at the short end of the  yield curve, at the long end of the yield curve.  But Reynolds has no problem showing that long-term interest rates rose almost from the get go.  To Alan this suggests that there was no stimulus, but on the contrary what the rise in long-term interest rates shows is how effective the stimulus was in improving expectations of future cash flows.  The improving expectations of future cash flows fueled the rise in stock-market values starting in September (after a miserable August 2010 in which stocks fell by about 8 to 10%).  (The S&P 500 rose from 1047.22 on August 26, 2010 to 1343.01 on February 18, 2011.)  In my paper, “The Fisher Effect under Deflationary Expectations,” I provided evidence that the stock market, in contrast to what one would expect under normal conditions, has since 2008 gone up and down in close correlation with changes in inflation expectations.  I discussed this phenomenon in a previous post.

Alan thinks that because the dollar fell against the euro from $1.27/euro to over $1.40/euro, and because commodity prices rose fairly sharply (perhaps by 25% in the six months after QE2 was announced) that there was no benefit from monetary expansion.  Again, Alan has a bit of an excuse for his misunderstanding because those explaining the program, e.g., Christina Romer, Obama’s chief economist at the time (and a good one at that who should have known better), explained that a declining dollar would make US exports more competitive in world markets, failing to point out that there is a countervailing tendency.  Alan correctly points out that a weaker dollar also makes imported products more expensive, so that the dollar cost of imported raw materials and capital equipment rises, diminishing the gain from a cheaper dollar to US exporters.  However, US wages don’t rise (at least not without a very long lag) as a result of a falling dollar.  And since, for most businesses, wages are the largest cost item, the falling dollar did in fact help to increase the profitability of US exporters, something Alan himself confirms when, in a different context, he reports that the operating earnings per share of S&P 500 companies were $24.86 on June 30, 2011 compared to just $20.40 a year earlier.

It is the increased profitability associated with increasing the prices of output faster than cost that is the primary (but not the only) explanation of how QE2 was supposed to stimulate a recovery.  It was partially successful, as attested to by the increase in stock prices from September 2010 to February 2011.  However, the recovery was stalled by a string of one-off events that disrupted and partially reversed the increase in production that was getting under way:  a severe winter, a big runup in oil prices in February as a result of the shutdown of Libyan oil production, and the earthquake and Tsunami in Japan in March [update August 28, I failed to mention the effect of the European debt crisis which also began to worsen again at about that time].

I am sorry to say that Alan fudges a bit in discussing the increase in commodity prices in general and oil prices in particular.  He attributes the entire increase in oil prices to quantitative easing.  In fact between September and February oil prices rose about 20-25%, reflecting the increasing optimism of traders that a recovery was gaining traction.  That increase in oil prices was in line with the increase in other commodities.  The Dow Jones/UBS commodity price index increased about 30% between September 2010 and February 2011.  Since commodity prices, including oil, had dropped sharply after the 2008 crisis, it is not surprising that an anticipated recovery would have caused a significant rebound in the prices of commodities in general, and especially oil demand for which is highly sensitive to overall economic activity.  However, from February to April, crude oil prices increased another 20%, coinciding in the US with the spring changeover to higher ethanol requirements, driving gasoline prices to all-time records, thus dealing a blow to consumer confidence.

The first of the two charts below shows that although commodity prices increased sharply over the past year, they are still well below the levels reached in the summer of 2008 and about where they were in 2005.   Concerns about commodity price inflation seem greatly overblown

The next chart shows a comparison between the movements over the past year in the entire DJ/UBS index and in the index of the Brent Crude benchmark.  One can see that the DJ/UBS index increased between August and February and then leveled off, while Brent Crude increased sharply just when the broader index peaked.  Only in May did oil prices moderate somewhat before falling sharply over the past month when markets began to take fright at the prospect of deteriorating economic conditions and policy paralysis.  [Update August 28:  a further fall in oil prices induced I think by the sudden success of the Libyan rebels, raising hopes of a restoration of Libyan oil production is particularly significant and I hope to follow up with a post on Libyan developments later this week.]

In short, my old friend Alan Reynolds blames everything bad that has happened over the last year on monetary causes, but can’t provide a coherent explanation for why monetary expansion would not stimulate the economy, something even Robert Barro was willing to concede as recently as January 22, 2009 in the Wall Street Journal editorial page.

Readers of this blog may have guessed by now that I am not a fan of The Wall Street Journal editorial page.  (Actually that is not entirely true.  The Journal editorial page is my go-to source of material whenever I am looking for something to write about on the blog.  So the truth is that I am deeply indebted and eternally grateful to the Journal.)  But I have to admit that even I was not quite prepared for Robert Barro’s  offering in today’s Journal.  You don’t have to be a Keynesian economist – and I have never counted myself as one – to find Barro’s piece, well, let’s just say, strange.

Barro is certainly more sophisticated than Stephen Moore who, having discovered, 75 years after Keynes wrote the General Theory, that Keynesian economics defies common sense, tried and failed to apply the coup de grace to Keynesian economics.  Employing a variation on Moore’s theme, Barro, with a good deal more sophistication than Moore, draws the contrast not between Keynesian economics and common sense but between Keynesian economics and regular economics.

Regular economics is the economics of scarcity and tradeoffs in which there is no such thing as a free lunch, in which to get something you have to give up something else.   Keynesian economics on the other hand is the economics of the multiplier in which government spending not only doesn’t come at the expense of private sector spending, amazingly it increases private sector spending.  Barro throws up his hands in astonishment:

If [the Keynesian multiplier were] valid, this result would be truly miraculous.  The recipients of food stamps get, say, $1 billion but they are not the only ones who benefit.  Another $1 billion appears that can make the rest of society better off.  Unlike the trade-off in regular economics, that extra $1 billion is the ultimate free lunch.

Quickly composing himself, Barro continues:

How can it be right?  Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?  Keynes in his “General Theory” (1936), was not so good at explaining why this worked, and subsequent generations of Keynesian economists (including my own youthful efforts) have not been more successful.

Nice rhetorical touch, that bit of faux self-deprecation, referring to his own fruitless youthful efforts.  But the real message is:  “I’m older and wiser now, so trust me, the multiplier is a scam.”

But wait a second.  What does Barro mean by his query:  “Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?”  Where is the market failure?  Hello.  Real GDP is at least 10% below its long-run growth trend, the unemployment rate has been hovering between 9 and 10% for over two years, and Professor Barro can’t identify any market failure?  Or does Professor Barro, like many real-business cycle theorists (say, Charles Plosser, for instance?), believe that fluctuations in output and employment are optimal adjustments to productivity shocks involving intertemporal substitution of leisure for labor during periods of relatively low productivity?

Perhaps that is what Barro thinks now, which would be interesting to know if it were the case, but about two and a half years ago, writing another op-ed piece for the Journal, Barro had a slightly different take on what is going on during a depression.

[A] simple Keynesian macroeconomic model implicitly assumes that the government is better than the private market at marshalling idle resources to produce useful stuff.  Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out.  In other words, there is something wrong with the price system.

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels.  But this problem could be readily fixed by expansionary  monetary policy, enough of which will mean that wages and prices do not have to fall.

So in January 2009, Barro was at least willing to entertain the possibility that some kind of obstacle to necessary price and wage reductions might be responsible for the failure of markets to generate a spontaneous recovery from a recession, so that a sufficient monetary expansion could provide a cure for this problem by making wage-and-price reductions unnecessary.  But if that is what Barro believed (and perhaps still believes), it would be interesting to know if he thinks that monetary expansion, which, after all, can be accomplished at very little cost in terms of resources or foregone output is not somehow inconsistent with his conception of regular economics.  I mean you print up worthless peices of paper and, poof, all of a sudden all that output that private markets couldn’t produce gets produced, and all those workers that private markets couldn’t employ get employed.  In Professor Barro’s own words, How can that be right?

But let us assume that Professor Barro, obviously a very, very clever fellow, has an answer to that question, so that trying to increase output and employment by printing up and distributing worthless pieces of paper is not at odds with regular economics, while trying to do so by government spending – quintessential Keynesian economics – must therefore contradict regular economics.  Well, then, let’s ask ourselves how is it that monetary expansion works according to regular economics?  People get additional pieces of paper;  they have already been holding pieces of paper, and don’t want to hold any more paper.  Instead they start spending to get rid of the the extra pieces of paper, but what one person spends another person receives, so in the aggregate they cannot reduce their holdings of paper as intended until the total amount of spending has increased sufficiently to raise prices or incomes to the point where everyone is content to hold the amount of paper in existence.  So the mechanism by which monetary expansion works is by creating an excess supply of money over the demand.

Well, let’s now think about how government spending works.  What happens when the government spends money in a depression?  It borrows money from people who are holding a lot money but are willing to part with it for a bond promising a very low interest rate.  When the interest rate is that low, people with a lot cash are essentially indifferent between holding cash and holding government bonds.  The government turns around and spends the money buying stuff from or just giving it to people.  As opposed to the people from whom the government borrowed the money, a lot of the people who now receive the money will not want to just hold the money.  So the government borrowing and spending can be thought of as a way to take cash from people who were willing to hold all the money that they held (or more) giving the money to people already holding as much money as they want and would spend any additional money that they received.  In other words, i.e., in terms of the demand to hold money versus the supply of money, the government is cleverly shifting money away from people who are indifferent between holding money and bonds and giving the money to people who are already holding as much money as they want to.  So without actually printing additional money, the government is creating an excess supply of money, thereby increasing spending, a process that continues until income and spending rise to a level at which the public is once again willing to hold the amount of money in existence.

Now I am not saying that the two approaches, monetary expansion via printing money and government spending by borrowing, are exactly equivalent. But I am saying that they are close enough so that if restoring full employment by printing money does not contradict regular economics, I have trouble seeing why restoring full employment by borrowing and government spending does contradict regular economics.  But I am sure that Professor Barro, very, very clever fellow that he is, will clear all this up for us in due course, perhaps in a future op-ed in my go-to paper.

I used to think that the most important objective for monetary policy was to stabilize the price level, and that it mattered less which particular price level was stabilized than that some price level be stabilized.  I thought that really bad things happen when there is inflation or deflation, but if the price level — any reasonably broad price level — could be stabilized, whatever fluctuations occurred would be of a second order of magnitude compared to the high inflation or substantial deflation liable to occur without an explicit commitment to price-level stabilization.  I also thought, having learned  Friedman’s lesson of  the natural rate of unemployment a little too well, that aiming for price-level stability would made it unnecessary to worry about preventing unemployment, because high and long-lasting unemployment could not occur without falling prices.  That seemed to imply that if you could just ensure that monetary policy would keep prices broadly stable, unemployment would take care of itself.  In other words, deliberately trying to reduce unemployment would only get you a temporary reduction in unemployment at the cost of a permanent increase in inflation; a bad bargain, or so, at any rate, it seemed to me.

That was one of the main messages of my book Free Banking and Monetary Reform in which I advocated stabilizing the expected wage level (via a mechanism invented by Earl Thompson).  Although I pointed out that stabilizing an output price index could have undesirable effects in case of a supply shock that raised input prices, in retrospect I don’t think that I took that contingency as seriously as I should have.  If you try to keep the level of prices constant in the face of such a supply shock, you will succeed only if you can force down nominal wages or the return on investment.  Either one is a recipe for a major recession.  If you allow output prices to rise to reflect the increased cost of inputs, real wages will fall without a reduction in nominal wages, avoiding the costly adjustment (i.e., reduced output and employment) associated with trying to effect a reduction in nominal wages.

But the problem goes even deeper than that.  Suppose you have a central bank that is credibly committed to stabilizing the price level or to stabilizing the rate of inflation at some target level, say, just to pick a number at random, about 2% a year or slightly below that.  Then suppose that there is a supply shock, so that the central bank has basically two choices.

The first would be for the central bank to allow the supply shock to work its way through the system, enabling producers to pass through their increased input costs to consumers by providing enough monetary expansion to allow increased input costs to be added to output prices without forcing any other inputs to absorb a nominal reduction in their nominal incomes.  Thus to avoid a recession, you would probably need a slightly higher rate of NGDP growth than the rate corresponding to to the one that would have met the inflation target had there been no supply shock.  In other words, I am suggesting, though I could be wrong about this, and I invite others to weigh in on this point, that accommodating the supply shock requires a slight loosening of monetary policy relative to what it was before the shock.  But if the central bank accommodates the supply shock, it will overshoot its inflation target, undermining its precious inflation-fighting credibility.

The second option of course is to resist the supply shock in order to maintain the precious inflation-fighting credibility of the central bank.  But this requires the central bank to tighten its policy, because unless policy is tightened some part of the unexpected increase in input prices will get passed forward into the price of output, forcing the realized rate of inflation to rise above the target rate.  The tightening of policy therefore necessarily results in reduced nominal incomes to other inputs (i.e., labor and capital) causing a decline in real output and employment.

At least in broad outline (though I (or we) perhaps have to do some more work on the details), there is nothing really new in this discussion.  But I think that there is something else going on here that is not so well understood.  The part that is not so well understood is that if the public understands that the central bank cares more about its precious inflation-fighting credibility than about causing a recession, the public will anticipate that the central bank will tighten monetary policy, which means that the public will immediately increase its precautionary demand for money, which means a spontaneous demand-induced tightening of monetary policy even before the central bank lifts a finger.

I have no doubt that something like this was going on in the spring and summer of 2008 when the FOMC kept making periodic and downright scarry statements about how increases in headline inflation caused by rising commodity prices (Oh, Lord, protect us from those rising commodity prices!) were threatening to cause inflation expectations from becoming unanchored even as the economy was rapidly going down the tubes long before the Lehman debacle (and don’t forget that it took the FOMC three whole weeks after Lehman collapsed — during which time there was an already scheduled FOMC meeting at which the status quo was reaffirmed! — to reduce the federal funds rate to 1.5% from the 2% rate at which it had been held since March).

And I also believe that something like this has been going on over the past few weeks as inflation and money-printing hysteria has increased, fueled, among other things, by an unexpected 0.5% increase in the July CPI.  I am suggesting that the 0.5% increase in the CPI caused the markets to attach an increased probability to a tightening of monetary policy, causing an increased precautionary demand for money.

In chapter 10 of my book (pp. 218-21) in the section “the lessons of the Monetarist experiment 1979-82,” I described the perverse expectational reactions triggered by the Fed’s attempt to follow the Monetarist prescription for targeting the growth rates of the monetary aggregates.  I introduced that section with the following prescient quotation from Hayek’s Denationalization of Money.

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if under such a provision it ever became known that the amount of cash in circulation was approaching the upper limit and therefore a need for increased liquidity could not be met

The perverse response under inflation targeting when there is a supply shock is, I think, more or less analogous to the one so clearly foreseen by Hayek, which I documented in my book for the 1979-82 period (with intermittent recurrences in 1983-84 as well).  Who says history never repeats itself?

In last Tuesday’s Financial Times, Raghuram Rajan wrote an op-ed piece entitled “Why we cannot inflate our way out of debt.”  Here is how it starts:

We are experiencing financial panic. A downgrade of US debt has triggered a flight to liquidity towards the very assets downgraded. Ultimately, the cure for market paranoia is strong economic growth. Several commentators propose a sharp, contained bout of inflation as a way to reenergise growth in the US and the industrial world. Are they right?

To understand the prescription, we must understand the diagnosis. Recoveries from crises that result in over-leveraged balance sheets are slow, and are typically resistant to traditional macroeconomic stimulus. Over-leveraged, households cannot spend, banks cannot lend and governments cannot stimulate. So why not generate higher inflation for a while? This will surprise fixed income lenders who agreed to lend long term at low rates; bring down the real values of debt; eliminate debt “overhang”; and spur growth. Yet there are concerns. Can central banks with anti-inflation credibility generate sharply higher inflation in an environment of low rates? Will it work as intended? What could be the unintended consequences? And are there better alternatives?

In reply, I sent the following letter to Financial Times, which was not printed.

Sir, Raghuram Rajan (“Why we cannot inflate our way our of debt” August 16) argues that inflation is not the answer to the debt overhang weighing down the international economy and holding back its recovery.  Professor Rajan offers four reasons for skepticism that inflation can solve our debt problem: 1) that it will squander dearly bought central bank credibility; 2) that it may fail to stimulate growth as promised; 3) that it will have unwanted side effects, e.g., reducing real wages and harming bondholders; and 4) narrowly targeted relief for debtors could be provided and would be more effective than inflation in relieving the debt burden.

Unfortunately, Prof. Rajan fails to grasp, or chooses to ignore, several important reasons why inflation is our best hope for escaping the depression in which we are now stuck.

First, rising prices and the expectation of rising prices instantly encourage production, enhancing incentives for businesses to increase output, hire additional workers, and undertake new investment instead of continuing to accumulate idle cash.  The prospect of rising prices will would also encourage households to increase purchases of consumer durables instead of paying down their debt.

Second, any stimulus to output when an economy is beset with chronic unemployment and idle capacity tends to induce further increases in output.  The yield on 5-year inflation-adjusted Treasuries is almost minus 1 percent.  That is a measure of the extreme pessimism about future economic conditions now pervading the markets, discouraging real investment and growth in a vicious cycle of self-fulfilling gloomy expectations.  Increasing inflation expectations and output would promote further improvements in expectations. initiating a virtuous cycle of self-fulfilling optimistic expectations and rising real interest rates, encouraging new investment and reducing desired holdings of cash.  This is why an unusual positive correlation began to emerge in 2008 between changes in inflation expectations and changes in the S&P 500 stock index. The correlation, which continues to be observed even now, is documented in my paper “The Fisher Effect Under Deflationary Expectations” available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1749062.

Third, central bank credibility is worthless if it supports — even encourages — such expectations of stagnant or declining future output as now exist (otherwise the real yield on 5-year Treasury could not be negative).  Central bank credibility would not be squandered if they announced an explicit price-level target at least 10 percent above the current level and pledged to reach that target within two years.  Alternatively they could announce targets for nominal spending (NGDP) to grow by 8 to 10 percent for at least the next two years.

Finally, the tendency for rising prices to depress real wages is largely transitory, and, in any case, would be more than offset in the transition by falling unemployment.  Similarly, the harm to bondholders and banks from the erosion of the real value of their assets would be offset by the increased likelihood that debtors would repay most of what they owed rather than default entirely, leaving  creditors with nothing but worthless paper. Only by ignoring all this, can Prof. Rajan imagine that targeted debt relief could be a substitute for a stiff dose of inflation.

Yesterday, the yield on the 10-year constant maturity Treasury was 2.17% and the yield on the 10-year constant maturity TIPS was 0.01%.  So the implied expected rate of inflation for a 10-year time horizon was 2.16%.  At the close of trading today, the corresponding rates were 2.08% and 0.09%, implying that expected inflation over the next 10 years fell to 1.99%, one of the largest single day declines in inflation expectations in the available data on 10-year TIPS going back to 2003.  Not coincidentally, the S&P 500 fell by 4.6%.

What can account for the decline in inflation expectations?  In my post earlier today I quoted from today’s lead editorial in the Wall Street Journal.  Let me quote the passage in its entirety.

Merely by raising the Fed as a subject, Mr. Perry has sent a political signal to the folks at the Eccles Building to tread carefully as they conduct monetary policy in the coming months. This alone is a public service. Mr. Perry and the other GOP candidates should be more careful in their language, and more precise about the Fed’s mistakes. But they shouldn’t shrink from debating the subject of sound money that is so crucial to restoring American prosperity.

So the Journal, behind the cover of its admonition to Governor Perry to be more circumspect in his word choice, whole-heartedly endorses his message to the Fed not even to think about using monetary policy to promote economic recovery (“tread carefully as they conduct monetary policy in the coming months”), while encouraging other Republican candidates to join Governor Perry in sending that message to the Fed.  Today’s editorial was coupled with the bad news that the CPI rose by half a percent in July, way above the .2% that had been expected, encouraging further scare mongering about inflation, while strengthening the hand of those on the FOMC opposed to any further monetary easing.  Is it any wonder that the markets are revising their expectations of future monetary policy in a downward direction — in a sharply downward direction?

In the table below, I list 28 instances in which inflation expectations (measured by the TIPS spread on 10-year constant maturity Treasuries) suffered a decline of 11 basis points or more in a single day.  Only one such instance took place before 2008, on March 14, 2003; another occurred on March 17, 2008.  The remaining 26, have all occurred since the financial panic that occurred after the Lehman Brothers debacle in September 2008.  Of those 26 instances, 17 were associated with declines in the S&P 500 greater than 1%.

In a paper available here, and discussed here, here, and here, I have shown that until early 2008, the there is no systematic correlation to be found in the data between asset prices (measured by the S&P 500) and inflation expectations.  However, since 2008, the daily change in expected inflation (measure by the TIPS spread on 10-year Treasuries) has been highly correlated with the daily change in the S&P 500.  To me that is persuasive evidence that in current atypical economic conditions, characterized by unusually pessimistic expectations of future economic activity, raising expected inflation tends to improve expectations of real economic growth, thereby, in and of itself, promoting increased investment, output and employment.

One would think that conservatives, who profess to favor unleashing the private sector, would favor a policy calculated to encourage additional private investment and promote increased output by and hiring by American business without any increase in government intrusion into the economy.  Isn’t that what the magic of the market is all about?  That’s what one would  think, but the Wall Street Journal editorial page, in its almost infinite wisdom, seems to think otherwise.

After administering a pro-forma slap on the wrist to Texas Governor Rick Perry for saying that it would be treasonous for Fed Chairman Bernanke to “print more money between now and the election,” The Wall Street Journal in today’s lead editorial heaps praise on the governor for taking a stand in favor of “sound money.”  First there was Governor Palin, and now comes Governor Perry to defend the cause of sound money against a Fed Chairman who, in the view of the Journal editorial page, is conducting a massive money-printing operation that is debasing the dollar.

Well, let’s take a look at Mr. Bernanke’s record of currency debasement.  The Bureau of Labor Statistics announced the latest reading (for July 2011) of the consumer price index (CPI); it stood at 225.922.  Thirty-six months ago, in July 2008, the index stood at 219.133.  So over that entire three-year period, the CPI rose by a whopping 3.1%.  That is not an annual rate, that it the total increase over three years, so the average annual inflation rate over the whole period was less than 1%.  The last time that the CPI rose by as little as 3% over any 36-month period was 1958-61.  It is noteworthy that during the administration of Ronald Reagan — a kind of golden age, in the Journal‘s view, of free-market capitalism, low taxes, and sound money — there was no 36-month period in which the CPI increased by less than 8.97%, or about 3 times as fast as the CPI has risen during the quantitative-easing, money-printing, dollar-debasing orgy just presided over by Chairman Bernanke.  Here is a graph showing the moving 36-month change in the CPI from 1950 to 2011.  If you can identify which planet the editorial writers for The Wall Street Journal are living on, you deserve a prize.

“Mr. Perry,” the Journal continues, “seems to appreciate that the Federal Reserve can’t conjure prosperity from the monetary printing presses.”  A huge insight to be sure.  But the Journal is oblivious to the possibility that there are circumstances in which monetary stimulus in the form of rising prices and the expectation of rising prices could be necessary to overcome persistent and debilitating entrepreneurial pessimism about future demand.  How else can one explain the steady decline in real (inflation-adjusted) interest rates over the past six months?  On February 10 the yield on the 10-year TIPS bond was 1.39%; today the yield has dropped below zero.  For the Journal to attribute the growing pessimism to the regulatory burden and high taxes, as it reflexively does, is simply laughable now that Congressional Republicans have succeeded in preserving the Bush tax cuts, preventing any new revenue-raising measures, and blocking any new regulations that were not already in place 6 months ago.

The Journal concludes:

Merely by raising the Fed as a subject, Mr. Perry has sent a political signal to the folks at the Eccles Building to tread carefully as they conduct monetary policy in the coming months.  This alone is a public service.

Yes, and as I write this the S&P 500 is down 54 points, almost 5%.

Scott Sumner is trying to figure out the answer to that question in an interesting thread on his blog.  I just posted this comment.

Scott, Sorry I have not been following this thread and am just jumping in from out of left field, so pardon me if this has already been mentioned, but as you pointed out to me in an email, one also needs to take into account the uncertainty or riskiness of estimates of expected inflation. I think that it is quite plausible that the FOMC statement confused everybody and increased the perceived risk of TIPS, causing the BE TIPS spread to rise even though the mean expected inflation rate may not have risen or even fallen. It’s a jungle out there.

To elaborate slightly:  Last week when things started to fall apart, I flagged falling inflation expectations as a likely factor tending to push down stock prices.  For several days changes in stock prices and in inflation expectations (as reflected in the TIPS spread) were fairly closely correlated.  This week, however, the S&P 500 seemed to be decoupled from the TIPS spread.  I asked Scott in an email what his thoughts were about that, and he reminded me that the Cleveland Fed has a model in which the TIPS spread is decomposed into inflation expectations plus a risk factor.  (Sorry, I am rushed now so I can’t provide a link.)  My tentative hypothesis is that the FOMC confused everybody this week causing up and down movements in the stock market and an increase in the TIPS spread which reflected not an increase in expected inflation but increased risk in attempting to predict expected inflation.  Once again, a great job by the FOMC.

These are difficult times.  The sudden collapse of stock prices is not creating panic so much as despair, a despair voiced by Joseph Stiglitz in his column in the Financial Times today in which he correctly observes:

The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy.  But, even if it succeeds in stopping the slide in equity prices, it won’t provide the basis of recovery: it is not high interest rates that have been keeping the economy down.

Joseph Stiglitz is a brilliant economist, richly deserving the Nobel Prize he won in 2001, but it is shocking that he would assert that monetary policy can promote recovery only by reducing interest rates.  Evidently, that idea has been repeated so often and with such conviction that even an economist of Professor Stiglitz’s stature can unthinkingly parrot it without embarrassment.

Does Professor Stiglitz believe that if US monetary authorities decided to buy foreign exchange with dollars driving down the value of the dollar against other currencies, dollar prices would not rise?  And if foreign governments responded by purchasing dollars with their own currencies does he believe that prices in terms of those currencies would not rise?  Competitive devaluations would require no reduction in interest rates to be effective and would produce an immediate increase in money supplies and prices.  So it is clearly within the power of central banks, if they had the will to do so, to achieve any desired increase in the price level.  That the Fed and other central banks have not done so means only that they have not tried.

Stiglitz continues:

Corporations are awash with cash, but banks have not been lending to the small and medium-sized  companies that are the source of job creation.  The Fed and Treasury have failed to get this lending restarted, which would do more to rekindle growth than extending low interest rates though 2015

He is right that the Fed and Treasury have failed to get lending restarted, but fails to mention the primary reason: banks are being rewarded for holding reserves with a higher interest rate than they could earn by holding short-term Treasuries.  Returning to a zero-interest-rate policy on reserves or even imposing a tax on excess reserves would certainly change banks incentives, inducing them to reduce their holdings of reserves and to seek alternative ways, like lending to businesses and consumers, to generate income.

A similar sense of futility, though reflecting a profoundly different economic outlook from that of Professor Stiglitz is evidenced in The Wall Street Journal in its August 9 editorial on the FOMC’s announcement.

This is what a central bank does when it wants to appear to do something to help the economy but has already fire most of its ammunition.

But within two paragraphs, the Journal sharply pivots in its characterization of the Fed’s statement.  After noting the dissents of three FOMC members, regional bank presidents not appointed by President Obama, the Journal conjectures that:

the policy statement may have been a compromise, and that others on the committee would have gone further, perhaps so far as to start a third round of quantitative easing.

So the Journal itself seems to imply that the Fed’s statement ought to have been characterized as follows:  This is what a central bank does when it can’t agree to use the ammunition that it has.

The Journal, like Professor Stiglitz, pronounces the Fed’s quantitative easing a failure because all it accomplished was to “[push] investors into riskier assets (stocks and commodities).  But the prices of those assets have since fallen back down to what investors think they’re worth.”  It is almost surprising to read that the Journal believes that the Fed has power to push investors into anything, but readers of the Journal editorial page are no longer so easily surprised.  Investors make judgments, which may or may not be correct, on their own based on the policy signals emitted by the Fed.  If asset prices rose as a result of the Fed’s policy, it was because that was what investors, given the information they then had, felt the assets were worth.  If the assets fell in price later, that was because investors revised their expectations, presumably in light of new information, including new information about the Fed’s policy intentions, as well as the intentions of other relevant policy makers.

The Journal presumes that QE2 was intended to produce wealth effects that would increase consumer spending.  In this presumption, the Journal actually has some support from unfortunately inaccurate explanations of how the program would work by Mr. Bernanke himself.  But such wealth effects were, in the Journal’s view, offset by the negative “income effects” occasioned by the commodity-price bubble induced by QE2. 

Economic growth has decelerated over the past year despite QE2, so we wonder what good Mr. Bernanke thinks it did.  We’re hard pressed to see what good QE3 would do as well.

We know that QE2 was intended to prevent inflation expectations from falling to dangerously low, even negative, levels, as they seemed about to do last summer.  And in this it was successful.  The deceleration in growth was associated with a series of unfortunate one-off events: severe winter weather, a spike in oil prices as a result of the Libyan uprising against Colonel Ghaddafi, and the tsunami and nuclear disaster in Japan.  But rather than accommodate these supply shocks by allowing prices to rise as would be natural in the face of a supply shock, pressure built to tighten monetary policy to counter the supply-driven rise in prices, with results that are now becoming all too evident:  rapidly falling inflation expectations and real interest rates.

The correct explanation of how QE2 was supposed to work is that it would raise the cost of holding liquid assets that would lose value as prices rose.  That is why, within a few months after QE2 was initiated interest rates actually rose along with stock prices, contrary to the Journal’s story about “pushing investors into riskier assets.”  This would have induced business to shift some of their cash holdings into real investment rather than watch their idle cash lose value and to induce consumers to shift depreciating cash into consumer durables.

The notion that QE2 was undermined by a commodity price bubble is nothing but an urban legend.  I apologize for being unable to reproduce the graph on the blog, but if you go to here, you will find the Dow-Jones/UBS commodity index and you will see that that at the peak of the so-called commodity price bubble in April 2011, the index was at the same level it was at in September 2005 and 20% less than it was in July 2008.  The jump in food prices was largely the result of bad wheat harvests and US ethanol subsidies that have driven up the price of corn to unprecedented heights and caused farmers to shift production from other crops to corn.

The Journal then delivers the following piece of wisdom:

The larger error is to assume that monetary policy will save the economy from its current malaise.  That’s the latest mantra from the same economists who told us that $1 trillion in spending stimulus was the answer in 2009.  Since that has failed, we are now told the economy needs a bout of extended inflation to reduce our debt burden.  Harvard’s Kenneth Rogoff says the Fed should allow “a sustained burst of moderate inflation, say 4-6% for several years.”

That may be the mantra of Keynesians, but it is also the policy advice that has consistently been given by monetary economists of various stripes who have warned since 2008 that an overly tight monetary policy would produce a recession and that Fed policy, because of its payment of interest on reserves, has not been the least bit expansive despite the rapid increase in the Fed’s balance sheet.  Fiscal policy may have failed, but monetary policy has yet to be tried.

The Journal concedes that inflation can erode the value of money and debt, a truism too obvious for even the Journal to dispute.  But the Journal counters with the withering observation that Argentina tries this every few years, as if Argentina were the model that Rogoff and others advocating a rapid but limited increase in the price level were offering for emulation.

“The middle class,” warns the Journal, “pays a huge price in a debased standard of living.”  But the standard of living depends primarily on the real level of output and employment.  And there are powerful theoretical reasons to expect that a substantial rise in prices would trigger a large increase in output and employment, restoring living standards to levels not seen in years.  In addition, the historical example of FDR’s devaluation of the dollar in 1933 provides striking empirical evidence that for an economy with very widespread unemployment a period of rapidly rising prices can induce a substantial increase in output and employment.  In the four months following FDR’s devaluation of the dollar, wholesale prices rose by 14 percent, and industrial output rose by 56%, while the Dow Jones average doubled, the fastest increase in output and employment in US history.

“Once you encourage more inflation, it’s hard to stop at 4%,” asserts the Journal as if it were laying down a law of nature.  But there is no economic theory to support such a proposition.  If the Fed announced a specific price level target, there is no reason why it could not reach the target, and, having reached the target, no reason why it could not remain there or revert back to a sustainable long-run price-level path.

“If monetary policy by itself could conjure growth, or compensate for bad fiscal and regulatory policy,” the Journal reasons, “we’d already be booming.”  The Journal simply fails to grasp an elementary distinction: the difference between, on the one hand, the long-run potential rate of growth of an advanced economy, roughly 3% a year over long periods of time, a rate determined by real forces including the incentives provided for investment in the stock of human and physical capital, a stable legal system and efficient tax and regulatory policies, and, on the other, the job of restoring an economy to a long-run growth path from which it has lapsed.  With the former, monetary policy, indeed, has little to do; for the latter, as F. A. Hayek recognized in The Road to Serfdom (p. 121) monetary policy is preeminently responsible.

There is, finally, the supremely important problem of combating general fluctuations of economic activity and the recurrent waves of large-scale unemployment which accompany them.  This is, of course, one of the gravest and most pressing problems of our time. . . . Many economists hope, indeed, that the ultimate remedy may be found in the field of monetary policy, which would involve nothing incompatible even with nineteenth-century liberalism.

After the FOMC issued its statement yesterday, the S&P which had been down almost 2 percent rose about 6 percent to close up for the day by about 4 percent.  Presumably, this allayed fears that the Fed would passively allow inflation and NGDP to keep falling.  For the day, the TIPS spread depending on which measure you look at was constant or rose slightly.  However, the yield on Treasuries dropped by 20 basis points on both the 5- and 10-year bonds.  So the real yield dropped by 20 basis points or so, which says that profit expectations are falling or perceived uncertainty is rising.  Nevertheless, the mild and not very helpful statement was at least able to stop the bleeding.  NPR says that Dow futures are down 1 percent before the market opens in a half an hour.  I am not at all sure that the FOMC statement will be enough to turn the tide.  But I also thought that Bernanke’s Jackson Hole speech last August would not do the trick, and it in fact did succeed in turning things around (for a while).  Hold on to your hats.

PS  Does anyone know by how much the yields on the 5- and 10-year Treasuries and TIPS changed after the FOMC press release?